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:

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:

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:

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:

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.”

Editor’s Note: For further information on this subject, see the AICPA coursebook, GUE-PM-99, Introduction to ESOPs, by Steven M. Etkind, LLM, CPA. For information on life insurance in general, see “Life Insurance: Dispelling Illusions” by Joseph E. Godfrey III, CLU, in The CPA Journal (September 2001)
Thomas W. Morris
The CPA Journal

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