What is an ESOP?

An ESOP is a tax-qualified retirement program that owns stock of the sponsoring company for the benefit of its employees. It is important to note that ESOPs are subject to the same regulations and limitations as any tax-qualified retirement program, such as a 401K.

What makes an ESOP different from other plans is that it is effectively used as a corporate finance tool as well as a retirement vehicle for its participants. The major distinction between an ESOP and other plans is that an ESOP can borrow money to purchase its sponsors stock either from shareholders or directly from the company.

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

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

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

Shareholder Advantages

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

ESOPs work to either facilitate ownership succession or for buying out dissident shareholders. The shareholders selling their shares to the ESOP may be able to obtain a tax deferral by using the section 1042 tax-free rollover. This enhances the value of the buyout through the tax deferral, which maximizes cash to the shareholder. Also, leveraged ESOPs used to fund the buyout of a partner provide a reduced cost to the agency because interest and principal repayments are fully tax-deductible.

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

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

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

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

Company Advantages

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

Tax laws only allow agencies to deduct interest costs from conventional lending sources. However, a leveraged ESOP allows for deduction of both principal and interest costs.

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

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

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

Agency owners should at least consider establishing an ESOP in order to take advantage of the substantial tax incentives created by Congress to encourage their use. ESOPs present tax-savings opportunities for all business owners that cannot be compared to any 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 serial publication. All rights reserved.Copyright in this article as an independent work may be held by the author.