The ESOP financing technique was endorsed by Congress in 1976 and since that time has functioned to provide a ready market for the generally unmarketable stock of closely held corporations.
ESOPs have removed many of the negative tax implications–as well as other uncertainties–regarding the timing and regularity of buyout payments that generally accompany a third-party sale.
ESOPs are widely known as a cost-effective defined contribution retirement plan. They may be set up as either a profit-sharing or money-purchase plan and invest primarily in employer securities.
Once an ESOP trust is created, it is often funded with tax-deductible contributions of either newly issued corporate stock, cash, or both. The size and frequency of the employer’s contribution to the ESOP is at the discretion of the board of directors.
The contribution of newly issued stock is essentially a cash-less paper transaction that can enhance the corporation’s working capital position. The corporations cash contributions can create an immediate ESOP market for existing shareholders who desire to sell their stock.
A properly designed ESOP allows the owner of the company to maintain control since plan participants need not be given voting privileges and need not have any influence over company policymaking decisions. Employees only acquire a beneficial interest in their allocated account values.
The ESOP trustee is the stockholder of record, not the plan participants. A board of director’s appointed special committee generally votes on behalf of the shares owned by the ESOP.
Significant flexibility and additional tax advantages can be realized with a leveraged ESOP. A leveraged ESOP is the only qualified plan that can borrow from a third party to purchase either outstanding stock of major shareholders, newly issued stock of the company, or even the stock of a competitor corporation.
Up to 25% of the compensation paid to employee ESOP participants is deductible by the employer if those contributions are used to repay the ESOP’s loan principal. Additional employer contributions can be deducted without limits that are used by the ESOP to repay the interest on its loan obligation. Even dividends paid on the stock acquired by the ESOP are deductible if such dividends are used to repay the loan.
Reproduced from National Underwriter Life & Health/Financial Services Edition, March 4, 2002. Copyright 2002 by The National Underwriter Company in the serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.