Fundamentals of ESOPs for S Corporations
Employee stock ownership plans (ESOPs) originated in 1974 with the passage of the Employee Retirement Income Security Act (ERISA)1. The intent of ERISA was to offer incentives for companies to allow employee participation in ownership.
An ESOP is considered a qualified retirement plan under the Internal Revenue Code (IRC). To establish an ESOP, a firm forms a trust that purchases the shares of a company from the owner and allocates the shares to employees as part of their compensation. ESOPs allow business owners to diversify their wealth and provide employee ownership in the company. Upon retirement, employees may sell their shares back to the ESOP or retain their ownership interest.
Beginning in 1997, the Small Business Job Protection Act of 1996 (SBJPA) allowed for the adoption of ESOPs by S corporations.2,3 Since then, the number of ESOPs has increased exponentially. The National Center for Employee Ownership estimates the number of total ESOPs, stock bonus plans, and profit sharing plans invested primarily in employers’ stock has grown from 1,600 in 1975 to 10,500 in 2009, with almost 13 million plan participants today.4 ESOPs provide considerable benefits to plan participants and the sponsoring company. However, ESOPs are subject to significant regulations. They typically require the expertise of multiple professionals, including legal counsel, tax professionals and independent financial advisors to assist with their formation, maintenance and liquidation.
Since all of the assets of the ESOP must be held in a trust, the assets must be managed by a trustee or fiduciary. The trustee(s) has a fiduciary responsibility to plan participants (i.e., employees) to act exclusively for the purpose of providing benefits to plan participants and beneficiaries.5 The trustee is responsible for negotiating the company stock purchase with the selling shareholder(s). This process requires the trustee to obtain financial advisory services from an investment bank or qualified business valuation firm, and the valuation must withstand review by the Department of Labor and Internal Revenue Service. Part of this requirement should include an opinion that the ESOP is not paying more than “adequate consideration” for the stock.6
An ESOP trust is financed with contributions from the sponsoring company or a leveraged transaction, or a combination of the two. IRC Section 1042(a) allows owners of C corporations to defer capital gains taxes on the proceeds received from ESOP financing.7 By purchasing qualified rollover securities, such as domestic equity of a C corporation, such a deferral may occur. However, this provision is not allowed for owners of S corporations. Instead, the IRC allows C corporations to take advantage of the 1042 sale, elect a conversion and subsequently be taxed as an S corporation.
Once shares are transferred to an ESOP, businesses can benefit from favorable tax treatment granted to S corporations. Under IRC Section 501(a), the trust which holds the ESOP shares is treated as a tax-exempt trust.8 Profits allocated to shares that are held by an ESOP are not taxable at the trust level. This potential reduction or elimination of the need to provide tax distributions provides S corporations that have established ESOPs significant flexibility in deploying capital. Funds retained at the corporate level can be used to reduce debt, reinvest in the business, or acquire the assets of other corporations through mergers and acquisitions.
S corporation ESOPs provide benefits other than tax benefits. ESOPs can serve as an exit strategy for business owners. ESOPs are also a method of aligning employees’ interests with those of their employer. According to a Rutgers University study that examined over 2,000 businesses, those that enacted ESOPs exhibited sales, employment, and sales/employee increases above those of comparable non-ESOP companies.9
Despite the advantages, there are also disadvantages to establishing an ESOP that should be considered. First, ownership of a business is diluted when shares are sold to an ESOP; it can often be difficult for owners of family businesses to give up control. Also, significant fees for attorneys and other professionals are required to ensure compliance with federal regulations. Finally, ESOPs are subject to qualified plan rules. All employees must have access to the ESOP and the businesses cannot discriminate in favor of management or highly compensated employees. There are significant penalties for ESOP plans found in violation of federal regulations.
Federal regulations place additional requirements on ESOPs owned by private companies that are not applicable to public firms. As the stock of private companies is not traded on an open market, private companies must obtain annual business appraisals for tax reporting purposes. In order to determine the fair market value of the stock held in the ESOP, discounts for lack of control, lack of marketability and the repurchase obligation must be considered.
S corporation ESOPs offer unique benefits to both business owners and their employees. However, the proper structuring and implementation of an ESOP is a challenging endeavor. Business owners must carefully consider whether the costs and dilution associated with ESOPs outweigh the potential tax savings and other benefits, and consult with appropriate legal and tax professionals for guidance.
1 “What is the Technical History of ESOPs?” The Menke Group. http://www.menke.com/information/about.php (9 April 2010).
2 The SBJPA established that a qualified tax-exempt shareholder (i.e., the ESOP trust) is counted as one shareholder for purposes of an S corporation. Therefore, an unlimited number of employees may join an ESOP retirement plan without exceeding the S corporation limit of 100 shareholders.
3 Internal Revenue Code Sec. 1361(c)(6).
4 “A Statistical Profile of Employee Ownership,” The National Center for Employee Ownership. March, 2010. http://www.nceo.org/main/article.php/id/2/ (9 April 2010).
5 Internal Revenue Code Sec. 401 (a)(28)(C) – Use of an independent appraiser
6 ERISA Section 3(18), 29 U.S.C. Section 1002 – Definitions – adequate consideration
7 Internal Revenue Code Sec. 1042(a).
8 Internal Revenue Code Sec. 501(a).
9 “Largest Study Yet Shows ESOPs Improve Performance and Employee Benefits,” The National Center for Employee Ownership. http://www.nceo.org/main/article.php/id/25 (9 April 2010).