THE CPA IN INDUSTRY

April 2002

ESOPs Rediscovered: Tax Advantages and Recyclable Refunding

By Steven M. Etkind and Joseph E. Godfrey III

Employee stock ownership plans (ESOP) were initially a part of the Employee Retirement Income Security Act of 1974 (ERISA). Louis A. Kelso, the lawyer and economist who was the father of ESOPs, had the basic idea that sharing equity with workers would lead to greater productivity, profitability, and wealth creation. Empirical evidence has proved this to generally be true. Later legislation has both expanded and contracted ESOPs. For example, as a result of the 2001 tax act, perceived abuses of the S corporation ESOP structure have been eliminated. But for most companies, an S corporation ESOP remains an exciting way to partially or completely eliminate income taxation.

ESOP Benefits

While most people think of ESOPs as a quirky retirement plan, they are in fact a unique lifetime liquidity tool, estate planning tool, and vehicle for structuring corporate finance transactions, with both tax and financial benefits. The tax benefits can be summarized as follows:

• Under IRC section 1042, the sellers of C corporation stock can reinvest the proceeds during their lifetime in qualified replacement property (QRP) and defer capital gains tax. QRP is considered to be securities of domestic U.S. operating companies, which means senior or junior equity or debt of public or private companies. Therefore, this excludes mutual funds, municipal bonds, or Treasury bonds. If the stock is held until death, the capital gains tax goes from tax-deferred to tax-free, with a step-up in basis to the date-of-death value, which becomes the value on the estate tax return through the end of 2009.
  
• The purchase of stock can be paid with pre-tax dollars because the retirement plan contributions are deductible under IRC section 404. In the typical leveraged recapitalization, leveraged buyout, or management buyout transaction, only the interest is deductible.
  
• Dividends on preferred or common stock, when used to repay debt, are deductible at the corporate level. This make an ESOP a corporate finance tool.
  
• S corporation ESOPs are not subject to current income taxation. If all of the company’s stock is owned by an ESOP, none of the income is subject to federal or state income taxation. The non-ESOP shareholders of an S corporation are subject to income taxation on the shares that they own, so part of the shares can be owned by an ESOP and part by others. The portion of the company ownership owned by an ESOP will not be subject to taxation, something unique in the field of taxation.

For example, consider an individual who buys some or all of a particular business as a strategic buyer, as a private equity investor in an leveraged buyout transaction, or as the existing management in a management buyout. The purchaser is happy because the debt is repaid with pre-tax dollars. A business in a 40% federal and state marginal tax bracket must earn $16,666,667 before taxes to repay $10 million in debt, leaving out the cost of interest, which is neutral because both have the same assumed interest. If the $10 million debt is repaid through pre-tax ESOP contributions, the after-tax cost is $6 million.

This mismatch of tax law effectively turns the leveraged recapitalization’s basic tax rules upside down, although studies at Northwestern University and Rutgers University prove that sharing equity with employee owners produces a statistically higher return on assets (ROA), total shareholder return (TSR), and stock price. While not every ESOP has been a success, stories abound of rank-and-file workers retiring with six- and seven-figure account balances that were converted into cash.

Businesses should consider the ability to completely defer taxation by using an S corporation ESOP structure. After a C corporation creates an ESOP plan, the shareholders sell their stock tax-free to the ESOP. After the sale is complete, the company converts to S status and annually prepares an S corporation income tax return. The income attributable to that percentage of stock owned by the S corporation flows through to the ESOP, which is not subject to either income taxation or unrelated business income taxation (UBIT). Thus, the company does not have to distribute cash to or from the ESOP to pay state or federal income taxes.

The benefit of the S corporation ESOP is so great that Congress limited the applicability of this structure for closely held S corporations in the 2001 tax act. If more than 50% of the stock of an S corporation ESOP is constructively owned by “disqualified persons,” then a 50% excise tax is imposed. A two-part test determines who is a disqualified person:

• A person who constructively owns more than 10% of the stock, and
  
• A person who, with attribution to other family members, owns more than 20% of the stock.

Some companies have become 100% employee-owned because the owners could see it was in their and their company’s best long-term interest to do so. The owners get their money out tax-free, the company completely stops paying federal and state income taxes, cash is kept in the business to finance future growth, and the employee owners participate in the long-term increase in the value of the enterprise. Everyone benefits, including the IRS, because ultimately more income and wealth are created, which was Kelso’s original idea.

The Exit Strategy

As employee-owners leave employment, whether through voluntary termination, layoff, retirement, disability, or death, they have the right to put their vested shares of stock back to the company and the company is obligated to buy it back. While any loans are still outstanding, there are special rules. Because the private company stock is not readily marketable, a methodology for determining value and raising cash is necessary. The financial or actuarial technique to calculate this is called an emerging repurchase liability study.

The following are basic techniques for financing this future accounting liability:

• Pay-as-you-go or terminal funding (i.e., doing nothing) only postpones the inevitable and causes the time value of money to work against the business owners instead of for them.
  
• Sinking fund techniques utilize deductible contributions to the ESOP (but once paid, the money is gone forever) or non-deductible balance sheet allocations (where earnings are taxed to the company on a current basis, but cash is made available to meet the put obligation).
  
• Corporate owned life insurance (COLI) allows for lifetime liquidity and cost-recovery financing at death.

A simplified example of how the latest generation of large-case COLI (with premiums generally in excess of $250,000 annually) would work for a group of employees in their fifties is as follows: An annual premium of $1 million will purchase a policy with a face amount of approximately $27 million. Numerous variables in the policy, including gender pricing, smoker pricing, and the type of underwriting, affect the COLI policy’s financial performance in terms of cash value build-up, tax-free withdrawals, and death benefits.

Given a $1 million premium, the large-case COLI solution has the following costs and benefits:

• Premiums are paid as a non-deductible balance sheet transaction:
  
• APB 8 says that the premium paid of $1 million less the first-year cash value increase of $978,000 equals the first year’s charge to earnings of $21,200.
  
• In the fifth year, assuming an asset-allocated 10% return on the underlying subaccounts run by multiple money managers, the cash value increases by $220,000 more than the premium paid of $1 million; these nonoperating financial earnings flow through the financial statements on a non-tax basis.
  
• Policy cash values build on a tax-deferred basis so that cash will be available to be withdrawn tax-free to meet the employer’s emerging repurchase
  liability/put obligation to buy the employee-owners’ stock.
  
• As employee-owners retire, the company withdraws cash values tax-free from the COLI policy to redeem stock:
  
• Employees receive cash that can be rolled over tax-free into an IRA.
  
• The corporation has treasury stock that it can slowly de-ESOP if desired, although this is unlikely for an S corporation.
  
• Treasury stock can be recontributed to the ESOP, creating a tax deduction without putting up any cash.
  
• Because the mortality table is still 100%, it is necessary to overlay one of the following assumptions about long-term death rates of all employee owners:
  
• Assume that all deaths occur at a particular age, such as at a life expectancy of age 80 (which is not realistic because half the deaths will occur before then);
  
• Assume that random deaths occur throughout the entire employee population by some stochastic process; or
  
• Assume that there is a “fractional mortality,” which actuarially kills off part of each participant until everyone is assumed dead some 50–60 years in the future.

This arrangement makes financing the emerging repurchase liability a form of “recyclable refunding” because there is a continual inflow of death benefits over time to recover the cost of the shares repurchased from retiring employee owners.

Therefore, COLI is the perfect cost-recovery financing tool because it will create “recyclable refunding” for the entire transaction over more than one generation. “Perfect” stands for “profitable employer recovery for ESOP costs, tax-advantaged.” It allows the cash to keep regenerating itself through the miracle of the life insurance contract. It is also the perfect solution because it allows for “prospective employer recovery for the ESOP cost tab.”

©2002 CPA Journal. Legal Notices

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