Meltzer Lippe: The Bottom Line

By: Ira R. Halperin, Richard Reichler and Chuong Pham
Long Island Business News
May 9, 2003

In the current economic environment, owners of private businesses generally have, at best, a limited market for their stocks. However, a mechanism exists which permits shareholders to sell a significant portion of their ownership while retaining continued control and deferring the tax on any resulting gain. It can also add significant cash flow to the company while enabling employees to obtain an ownership interest and participate in the company's equity appreciation. In this way it can be used as a restricted stock reward program that defers taxes to participants until they receive distributions. Even further, the mechanism can also provide a means to make acquisitions and repay corporate debt with pre-tax dollars. Yet, while an Employee Stock Ownership Plan ("ESOP") provides all of these benefits and more, it remains one of the least understood and utilized vehicles in the corporate and tax worlds.

An ESOP [like a 401(k) plan] is a qualified defined-contribution benefit plan. Under Section 1042 of the Internal Revenue Code, one or more shareholders are able to sell their stock to a company sponsored ESOP and, so long as certain conditions are met, defer the tax on any resulting gain. At the same time, selling shareholders can use various means to retain continuing operating control of the company.

ESOP contributions are tax-deductible up to certain limits and can be made in the form of cash or company stock. By contributing stock to the ESOP, the company gets a cashless tax deduction while enabling employees to obtain an ownership interest and participate in the company's equity appreciation. Vesting can also be used as a means of encouraging employee retention. For example, anyone with less than five years of service can be denied any benefit.

An ESOP is unique among qualified plans in its ability to borrow money to buy the stock of the company. As a result, a "leveraged ESOP" may be used as a technique of corporate finance. Under this arrangement, an ESOP borrows money from a bank or other lender and uses the proceeds to purchase the company's shares. In addition to contributions, the company can deduct dividends paid to the ESOP to pay principal and interest on the loan. Dividends passed through to employees are also deductible. The deduction for dividends makes nonvoting convertible preferred stock a favored security in ESOP transactions. If desired, selling shareholders can fund all or a portion of the stock purchase by accepting a promissory note, rather than cash, as consideration. Under both methods, the repayment of principal and interest is deductible which provides a very attractive form of debt financing.

A dual loan structure in which an "external loan" from a lender to the company is combined with an "internal loan" from the company to the ESOP is more often utilized. The use of different terms for the two loans can lead to additional benefits for the company.

ESOPs offer special tax benefits with respect to S corporations. Generally, the earnings of an S corporation flow through and are not taxed at the corporate level but rather at the shareholder level. If an ESOP is a shareholder, its share of the corporation's earnings would be exempt from tax even if they are not distributed. However, S corporation ESOP sales cannot qualify for the tax-free sale and reinvestment benefits of Section 1042.

The use of an ESOP requires careful planning, deliberate action and the meticulous observance of formalities. The type of securities sold to the ESOP and the reinvestment by the selling shareholders must meet various technical requirements. Procedural filing requirements must also be carefully followed. In addition, the ESOP must comply with various allocation and premature disposition rules to avoid adverse tax consequences to the sponsor. However, the vast benefits of an ESOP make insignificant these technical issues.