Using ESOPs to Buy Shareholder Interests

by Tabitha M. Croscut & Robert E. Brown

Is your corporate client looking for a tax leveraged device to finance the buyout of a major shareholder? Is your client looking for a succession plan that provides shareholder liquidity but avoids outright sale of the corporation? Does your client want to provide employees with an ownership stake to improve productivity? An employee stock ownership plan ("ESOP") may be the right tool.

An ESOP is a qualified benefit plan under the Internal Revenue Code. Unlike ordinary profit sharing plans and other ERISA plans, however, ESOPs may borrow money with the corporation’s guarantee in order to purchase a shareholder’s stock.

For example, an ESOP could borrow funds from a bank to purchase shares from a major shareholder. After the stock purchase, the corporation would make annual cash contributions to the ESOP sufficient to amortize the loan. The ESOP would then allocate stock to the accounts of individual employees as the loan is paid off.

The net tax effect of the transaction is that, unlike the case with an ordinary loan repayment, the corporation gets a deduction for the principal paid on the loan in addition to the normal deduction for interest.

The shareholder selling to an ESOP may be able to defer capital gain taxes on the proceeds of sale indefinitely. The shareholder could then use family LLCs or other estate planning vehicles to minimize the tax ultimately paid at death. In this way, an ESOP can help maximize the value of assets that ultimately flow to heirs.

Over time employees become beneficial owners of the sponsoring ESOP corporation. If the corporation elects to be taxed as an S Corporation under the Internal Revenue Code after 100% of the stock is owned by the ESOP, all future federal income taxes on corporate earnings are eliminated.

The successful implementation of an ESOP requires coordination among corporate counsel, ESOP counsel, estate planning counsel, financial advisors, accountants, valuators, and third party plan administrators.

(This piece was written by Tabitha M. Croscut and Robert E. Brown of Boylan, Brown, Code, Vigdor & Wilson, LLP. Tabitha and Rob are both members of the ESOP Association and the National Center for Employee Ownership.)