ESOPs Make Sense For Agencies

Employee Stock Ownership Plans have quickly become the fastestgrowing vehicle for a closely held business to create tax-efficientworking capital, develop a cohesive work environment or create aviable perpetuation strategy.

Such a concept is quickly reaching insurance agency owners whoface a myriad of challenges. These challenges include trying todevelop a funded growth strategy; making additional investments intheir own businesses; developing a perpetuation plan; andoptimizing employee productivity and morale. And accomplishing allof this in the most tax-advantaged manner.

ESOPs present a very viable solution to agency owners andprincipals who confront some or all of these challenges.

What is an ESOP?

An ESOP is a tax-qualified retirement program that owns stock ofthe sponsoring company for the benefit of its employees. It isimportant to note that ESOPs are subject to the same regulationsand limitations as any tax-qualified retirement program, such as a401K.

What makes an ESOP different from other plans is that it iseffectively used as a corporate finance tool as well as aretirement vehicle for its participants. The major distinctionbetween an ESOP and other plans is that an ESOP can borrow money topurchase its sponsors stock either from shareholders or directlyfrom the company.

Employers can make annual contributions of stock to the ESOP asan additional employee benefit. This is typically referred to as anon-leveraged ESOP.

The ESOP can borrow funds from an outside lender to purchase thecompany stock, creating a leveraged ESOP.

The advantages of ESOPs fall into two broad categories: theshareholder advantages and the company advantages.

Shareholder Advantages

The shareholder advantages facilitates ownership transfer, whichis a highly efficient way to transfer ownership of closely heldagencies. By utilizing the correct strategy, an agency can transferits ownership from one or more owners to others through the use ofa leveraged ESOP. This creates a very cost-effective way toadminister a perpetuation plan, whether it is staged over time orconducted all at once.

ESOPs work to either facilitate ownership succession or forbuying out dissident shareholders. The shareholders selling theirshares to the ESOP may be able to obtain a tax deferral by usingthe section 1042 tax-free rollover. This enhances the value of thebuyout through the tax deferral, which maximizes cash to theshareholder. Also, leveraged ESOPs used to fund the buyout of apartner provide a reduced cost to the agency because interest andprincipal repayments are fully tax-deductible.

If a shareholder elects to hold his stock until deceased, hisestate can use the ESOP to provide a mechanism for the agency toredeem the stock on a tax-deductible basis. The agency can thenmake tax-deductible contributions to the ESOP to pay for the stock,rather than using after-tax dollars to redeem the shares directlyfrom the estate. In this situation, the estate does not face thepossibility of selling some of the shares of stock back to theagency in order to raise cash to pay estate taxes.

Sale of the company stock to an ESOP can be tax-deferred for anindefinite period of time. This works by forming a leveraged ESOP,selling the owners shares to the ESOP and then reinvesting thesales proceeds in securities issued by qualified U.S. companies.There is a limited time to complete the investment in order toqualify for the tax-deferral.

This strategy allows agency owners to cash out on the value oftheir business and to completely defer federal income tax on theproceeds. But this benefit is available only to C corporationshareholders. (C corporations are entity forms that are taxed atthe company level instead of allowing income to pass through to theindividual shareholders for tax purposes.)

Utilizing the rollover available to C corporation shareholders,agency owners can obtain liquidity for all or a portion of theirownership within the agency. By reinvesting in qualified U.S.investments, they are not only deferring the capital gainstreatment on the sale, but they also can diversify their holdingswhich minimizes their personal risk.

Company Advantages

Among the company advantages are the fact that an agency canraise capital at a reduced cost. By forming a leveraged ESOP,agencies can quickly obtain capitalization for expansion or otherneeds. The greatest benefit of this method is that an agency canobtain a full tax deduction on the principal and interest repaymentof the loan.

Tax laws only allow agencies to deduct interest costs fromconventional lending sources. However, a leveraged ESOP allows fordeduction of both principal and interest costs.

Also, accessing capital through funding sources is much moreprobable, time-efficient and cost effective through ESOPs thanthrough other means such as venture capitalists and banks.

Looking to other advantages of an ESOP, it could improve acompanys culture by having all employees maintain “pride ofownership.” By allowing employees to participate in ownership ofthe agency, owners should see a rapid change in culture. The ESOPcan be effective in elevating employee morale, reducing employeeturnover and increasing productivity.

Many insurance professionals shy away from exploring the use ofESOPs due to their presumed complexities. A professional advisorcan provide guidance on their applicability and benefits. ESOPs dorequire the services of a qualified attorney.

Agency owners should at least consider establishing an ESOP inorder to take advantage of the substantial tax incentives createdby Congress to encourage their use. ESOPs present tax-savingsopportunities for all business owners that cannot be compared toany other planning technique.

Steven S. Wevodau is principal of WFG Capital Advisors LP,based in Harrisburg, Pa.

Reproduced from National Underwriter Property &Casualty/Risk & Benefits Management Edition, July 28, 2003.Copyright 2003 by The National Underwriter Company in the serialpublication. All rights reserved.Copyright in this article as anindependent work may be held by the author.