VOL. 113 | NO. 119 | Monday, June 21, 1999
By SUZANNE THOMPSON
Hopping on an ESOP
Companies use employee stock ownership plans to give executives an exit strategy and to offer employees incentives to build the company
By SUZANNE THOMPSON
The Daily News
When a shareholder at EnSafe Inc. decided to leave the company, officials decided to establish an employee stock ownership plan to provide an exit ramp for executives and to save taxes.
"We saved several hundred thousand dollars by using the ESOP," said Michael A. Wood, chief financial officer for EnSafe.
While it is not unusual for company founders to decide it is time to move on, selling shares outright can cause problems both for shareholders and employees.
"Often times, a person will build a company and then decide that they want to sell out, but they know if they sell out to a strategic buyer or a financial investor that many of their employees will lose their jobs," said Kelly Finnell, president of Executive Financial Services Inc.
If departing shareholders sell their shares to someone outside the company, capital gains tax would be due on the transaction.
Selling the shares to the company itself would cost the departing shareholder ordinary income tax.
"Using an ESOP will allow them to avoid that tax completely," Finnell said.
Congress created a special section of the Internal Revenue Code in 1984 that allows shareholders in that situation to sell to their ESOP on a tax-free basis, Finnell said.
In an ESOP, eligible employees are given a number of shares of stock depending on the amount of compensation they receive from the company.
This makes ESOPs an effective way to share the wealth of a company with employees and provide incentives for them to help build the value of the company, he said.
ESOPs also are a tool useful in corporate finance, Finnell said.
"If a company wants to expand its operations, build a new plant, buy a competitor, whatever it might be, that company can go to the bank and borrow the money to do that and deduct the interest on that loan.''
But, having the ESOP borrow the funds can be a more lucrative method for expansion.
"If thats the case, the company deducts not only the interest payments it makes on the loan, it also deducts the principal payments," Finnell said.
Borrowing the money through the ESOP converts what would have been a loan from the bank into a company contribution to a profit-sharing plan because the ESOP borrowed the money, he said.
The company then can make a cash contribution to the ESOP, which in turn, repays the bank loan.
Loans structured this way are considered a companys contribution to a profit-sharing plan.
"Thats what an ESOP is. Its a qualified profit-sharing plan," Finnell said.
The net result to the company is that the cost of borrowing money decreases by about 40 percent if the company is in a 40 percent tax bracket, which is the case with many companies that are taxed 34 percent on the federal level and 6 percent from the state.
For companies interested in establishing an ESOP, companies such as Executive Financial Services advise company executives.
"The first step thats involved in setting up an ESOP is helping a company determine what its objectives are and whether an ESOP is feasible to help it achieve those objectives."
Once thats been established, the second step is helping the company design the plan.
"What weve done with Mike and other ESOP companies is help them design the plan, write the plan and do the annual administration," Finnell said.
Provisions specific to an individual companys plan would include eligibility requirements, contribution rate and vesting schedule, he said.
The next step is communicating the plan to the employees. Once employees join the plan, they receive an annual statement that lets them know how much stock is in their plan and what that stock is worth.
Executive Financial Services fee to help companies establish an ESOP depends on the number of employees a company has.
The baseline fee for starting an ESOP is $2,500, plus $50 per participant. For a company with 100 employees, the fee would be $7,500 a year.
Valuation of a companys stock is an important aspect of any ESOP, and it is critical that an independent financial analyst be familiar with industry specifics to be able to accurately evaluate the stocks worth, Wood said.
Because Ensafe is an environmental and management consultant, the company engaged the services of Andrej Avelini, an independent financial appraiser in New York, who specializes in environmental engineering issues.
"Its important for an appraiser to understand what drives a business," Avelini said.
Avelinis fee for ESOP appraisals ranges between $10,000 and $25,000.
Company officials considering ESOPs for their businesses should act soon, however, because there is a proposal in President Clintons budget that would effectively eliminate ESOPs for S corporations, Finnell said.
If Congress approves that section of the budget, S corporations would not be allowed to create ESOPs after Jan. 1.
Although the budget doesnt specifically ban ESOPs, the budget proposes that all income from companies would be subject to a new tax known as "the unrelated business income tax," Finnell said.
"The net effect off all that is that ESOPs for S corporations would die. Presumably, any S corporation that currently has an ESOP would be grandfathered," he said.