With proper planning and execution, a leveraged ESOP can provide benefits to all parties of the transaction, including the company, the owners, the employees and lenders.
The most significant benefit for the company is the tax deduction for the contributions to the ESOP, which are essentially returned to the company and available to pay the Bank Loan. This represents a significant tax savings for the company and potentially increases after-tax cash flow compared to conventional debt financing.
The Owner/shareholder has created a buyer for a stock of his or her closely held company. In addition, if the selling shareholder meets certain criteria, he or she can take advantage of the 1042 election. Under Section 1042 of the Internal Revenue Code, the selling shareholder can defer the capital gains tax on the sale to the ESOP. If the company and shareholder transaction qualifies, the shareholder can purchase qualified replacement property (“QRP”) within 12 months and defer the taxes.
Many owners of closely held companies have a significant portion of his or her net worth tied up in the company. The sale to an ESOP can allow the owner to diversify his/her investments, while potentially retaining ownership control of the company. These events may also be beneficial to the individual shareholder’s estate plan.
The primary benefit for employees is the ability to share in the future growth of the company. Since the value of the company is dependent on its performance, employees may be more motivated to act in ways that maximize shareholder value.
Typically, ESOP contributions are larger than profit sharing contributions. ESOP contributions can even exceed 25 percent of annual compensation in certain situations. The larger contributions essentially accelerate the benefits to the employees compared to other qualified plans.
And, like other qualified retirement plans, the employee does not recognize taxable income when the shares are allocated to the participant’s account. Rather, taxable income is recognized when the participant receives a distribution from the ESOP.
We already identified that the company increases the after tax cash flows compared to traditional debt financing. This is a major benefit for lenders in ESOP transactions in the form of reduced credit risk. The tax savings increase after-tax flow and provide a greater chance that the company can pay its debt obligations to the bank in a timely manner. And if necessary, the ESOP transaction also can enhance credit if the selling shareholder pledges the QRP purchased in a Section 1042 rollover transaction as collateral for the Bank Loan. The shareholder is typically not adverse to the use of QRP as collateral, since it must be held for a certain minimum length of time in order to qualify for the tax deferral.
Fair Market Value after a Leveraged ESOP Transaction
While there are many benefits as outlined above, it is relevant to point out that after the ESOP purchases company stock, the value of the shares may initially drop. After the transaction, the company typically has a significant demand on cash for debt repayments. unless the company anticipates significant future cash flow enhancements, the fair market value of the ESOP shares immediately after the transaction is reduced.
The reduced value is often only temporary. If the company does not change significantly over the period the loan is amortized, this initial decrease in value is recouped as the debt is satisfied.