Employee Stock Ownership Plans (ESOPs)

Frost Brown Todd has helped businesses study whether an Employee Stock Ownership Plan (ESOP) is feasible and desirable. Our attorneys have designed and implemented ESOPs and have helped facilitate related corporate restructurings and governance changes. FBT also continues to represent small, large, new and mature ESOP-owned companies to address their unique compliance and governance issues. These issues are increasing in importance, as government audits increase and operational requirements become more complex.

There are generally several parties involved in an ESOP deal, each with slightly different interests, and any ESOP deal needs several key advisors. FBT has experience representing ESOP trustees who serve as fiduciaries to ESOP participants, and also sometimes represents shareholders who desire to sell their stock to an ESOP.

Most often, FBT represents the company that will serve as an ESOP plan sponsor and acts as a “quarterback” for other advisors—including a benefits administration firm, professional business valuation expert, the company’s regular outside accountants and general legal counsel, and FBT then assists company insiders, such as the management team and the company’s board of directors in understanding their role in an ESOP deal. Recently, a growing percentage of FBT’s ESOP practice has been to takeover legal work for an existing ESOP—particularly those formed by professionals who attempt to be a one-stop-ESOP-shop, who inevitably do not do all promised things well.

What is an ESOP?

An ESOP is a means of providing an identity of interest between a broad-based group of employees and the company. An ESOP is a tax-exempt, qualified employee benefit plan designed to invest primarily in employer securities; as the company contributes to the ESOP, ESOP participants build an equity stake in their employer. Because it is a qualified retirement plan, an ESOP provides a company-wide benefit and generally cannot provide a higher benefit, as a percentage of pay, for executives than for other eligible employees. 

Tax incentives for ESOPs have, in addition, transformed them into potential financing vehicles capable of generating significant economic benefits for corporations, and shareholders, and these incentives have made them useful as an acquisition vehicle.

An ESOP has the advantages of other qualified plans: currently deductible employer contributions, up to generous limits; earnings on contributions exempt from federal (and most state) income taxes, and deferral of tax on ESOP participants until they receive distributions. An ESOP, unlike other retirement plans, has a special exemption that allows this type of plan to buy stock in the employer—and it can borrow money to buy bigger blocks that become available. So, there are several unique ESOP advantages:

  • Deductible dividends - Company may deduct dividends on ESOP stock if paid in cash to ESOP participants within 90 days after the close of the plan year, or used to make payments on an ESOP loan incurred to purchase qualifying employer securities. (Not available to S corporations.)
  • Deductible principal payments and partially tax-free borrowing rates - A leveraged ESOP can lower the cost of raising capital.
  • If an ESOP is an owner of stock in a corporation that has made an election to be taxed as a pass-through entity under Subchapter S of the Code, all of the company’s income allocable to the ESOP’s percentage ownership is tax-free each year, because the ESOP is a tax-exempt entity.
  • If stock in a C corporation is sold to an ESOP, the seller can often defer income taxes on the gain in that sale, by claiming the benefits of Section 1042 of the Code.
  • A company founder can sell his ownership to an ESOP and stay involved in the business, assuring that the local legacy and jobs the founder created remain in the founder’s community.

An ESOP can borrow funds from the sponsoring company or a third-party lender (who typically obtains the company’s guarantee to contribute annually sufficient funds to the ESOP to amortize the loan). The ESOP then uses the cash proceeds of the loan to purchase company stock. As the company makes contributions every year, the ESOP uses those funds to repay interest and principal, and takes some of the stock purchased from the company out of a “suspense” or collateral account and allocates it among accounts of various participants/employees. 

An ESOP is frequently used to provide a market for a closely held corporation’s stock in a family-owned company where there is no family successor to own the business, or where the family wishes to diversify their financial fortunes to other types of investments rather than having all of its net worth in one business. It can also be a tool to assist management in an internal buyout of shareholders, and as an acquisition vehicle for complimentary businesses.

An ESOP as One of Several Alternative Employee Equity Incentives

Any business considering an ESOP needs to have advisors that are highly knowledgeable in all types of equity incentive arrangements often, an ESOP may not be the right answer for a particular situation. Employees can be given an incentive to improve the employer's financial performance in a number of ways, but executives often feel that giving employees a piece of ownership is the best way to create the correct incentives. There are a number of ways to deliver this ownership interest. If a company desires to provide equity as an incentive or succession planning tool to just selected employees, then stock grants, stock options, restricted stock, restricted stock units, performance shares, stock appreciation rights, phantom stock plans or a traditional management buyout transaction should be discussed.   

Why FBT for your ESOP Queries?

FBT has experts in all types of equity incentives, as well as other types of retirement programs. We can objectively describe the pros and cons of one alternative over another, so if an ESOP is not right for your company, we won’t try to sell you one. In addition, FBT also has a large and experienced corporate finance team to help with ESOP financing transactions, and numerous attorneys with experience in all merger and acquisition structures, whose creativity is often needed in an ESOP deal.  

FBT always manages an ESOP project by putting important education about ESOPs and key decision-making first—before large costs are incurred needlessly for a deal that might not happen.

We have proudly assisted in “making millionaires” by seeing ESOP companies we represent start, grow and then successfully sell a business to a larger enterprise—allowing a number of long-term employees to have more diverse and secure jobs as well as a healthy retirement account balance.

Practice Highlights

  • Business owners talked about an ESOP as early as 2000, but were content to continue to work hard to grow the business so they could sell at the height of its value, after working on grooming internal management successors. When illness of a key owner changed future plans in 2009, bank financing was tight. FBT helped the company structure a 100% purchase by a newly-formed ESOP, with mostly seller financing, and employment agreements that cemented plans for the succession in management that was needed for the company to remain strong. Warrants gave the sellers some continued “upside” if they continued to grow the business, but most future appreciation would create wealth for other employees.
  • FBT has assisted in the entire life-cycle of successful ESOP companies. One example: established the ESOP to preserve jobs in the face of possible closure due to loss of capital financing; counseled the company in governance and maintenance of the ESOP; and then represented the company in sale of ESOP’s stock to a public company after 11 years of growth.
  • An ESOP was formed after FBT carefully created a structure for participants to selectively transfer some assets from another retirement plan, so employees were able to buy stock from the estate of a founder who died suddenly—saving the company from possible liquidation.
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