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Thursday, November 15, 2012
This blog entry is a summary of a white paper prepared for BNA by
Keith Butcher, John Kober, and Jason C. Ray and adapted from a BNA Insight. The white paper is available at butcherjoseph.com.
ESOPs continue to be an increasingly attractive means of
transferring ownership in a family owned business in a manner that provides
fair market value to the owners, but also appeals to several passion points such
as continuing the legacy of the business, keeping the business (and jobs) in
the community and maintaining the continuity of the business. In addition to these passion points, ESOPs
can provide several unique tax benefits and byproduct benefits to the sellers
and the company.
As each year passes, many private businesses started and
owned by the baby boomer generation will be in transition. As the baby boomers retire, their exit
strategy will more than likely include the transfer or sale of their privately
owned business. The options typically considered are to sell to a competitor, sell to a financial buyer (ie. a
private equity group), transfer the business to the management team for a note
or sell the business to an ESOP.
The sale to an ESOP provides a financially attractive,
tax-advantaged, and socially accepted vehicle to effectuate the transfer of a
First and foremost, an ESOP is an employee benefit plan that
allows the employees to share in the economic benefits of owning a
company. In many ways, and ESOP is no
different than any of the other broad-based retirement plan. However, there are many additional benefits
associated with an ESOP becoming part of the capital structure of a business:
The business owner has a way to transfer and
sell his or her business interest (and the business owner may receive some tax
The company receives some tax benefits.
The employee receives some benefits.
With the uncertain tax environment facing business owners as
the Bush-era tax cuts expire and the long-term capital gains rate increases, it
is apparent that 2013 will impact a lot of business owners. Those that plan to sell their business will
loose a greater portion of the sale since the proceeds will be subject to
higher taxes. A unique benefit available
to the business owners who engage in an ESOP transaction for their C
Corporation is the potential to elect to defer long-term capital gains
recognition under a “1042 transaction.”
There are several other tax benefits to the company with an
ESOP as part of the capital structure.
They include deductions for contributions made to the leveraged ESOP, potential
tax deductions for the value of dividends paid, and in the proper situation, no
corporate income tax for S corporations.
Along with the several tax benefits associated with ESOPs
come many regulations that must be adhered to. Fiduciary responsibilities, proper structure and the role of the board
of directors are specific areas that need close attention.
Following the implementation of an ESOP into the capital
structure of the company, the shareholder is the ESOP trustee with the board
running the business affairs of the company.
Because interests may not always align, it is important to understand
the duties of the board, since the ESOP trustee is looking out for the best
interest of the ESOP participants. The
board, while not typically responsible as a fiduciary to the ESOP,
does fulfill a fiduciary role when selecting the ESOP’s trustee as the
fiduciary of the ESOP. Therefore, careful consideration of potential
conflicts must be made when selecting each member of the managing structure.
There are other many other benefits of an ESOP. ESOPs foster an environment that aligns the
interests of the company’s employees, managers, and shareholders and provides
them with the incentive to behave in ways that maximize the company’s
It is well documented that employees who have an ownership
stake in a business behave differently than those that do not. Ownership increases the level of motivation,
engagement, commitment and satisfaction.
Companies that combine an ESOP with participative management
tend to grow faster and operate more profitably than their peers. A Study
conducted by researchers at Rutgers University found that implementing an ESOP
causes sales, employment, and sales per an employee to be 2.3 percent-2.4
percent higher than would have been expected absent and ESOP. 
Successfully creating and managing and ESOP requires
compliance with a myriad of laws and regulations. Laws governing ESOPs promote good solid
corporate governance and help prevent unscrupulous persons from engaging in
self-dealing that may jeopardize the business and hurt its employees. There are several court cases that should be
reviewed that highlight the fall out that occurs when key corporate officials fail
to satisfy their legal duties to the ESOP and hurt the company. There are two important cases specifically that
demonstrate the importance of good corporate governance. They are Johnson vs. Couturier and the Alliance case. These cases are good examples of the
importance of separating control of the company from control of the ESOP, and
implementing a system of checks and balances.
The future is bright for ESOPs and the companies that decide
to implement them. ESOPs offer unique
advantages for shareholders to transition control and ownership of their
company. The tax advantages make ESOPs
attractive, not only as a form of employee benefit, but also as a technique of
corporate finance and as a business succession tool. Because tax rates are anticipated to increase
significantly next year, an ESOP can be an even more useful tool for the
selling shareholder today.
important limitation on fiduciary status is that a person is a fiduciary only
“to the extent” he performs one of the defined fiduciary functions. See id.; Pegram
v. Herdrich, 530 U.S. 211, 24 EBC 1641 (2000)(118 PBD, 6/19/00;27 BPR1519,
6/20/00). (“In every case charging breach of fiduciary duty, the threshold
question is not whether the actions of some person employed to provide services
under the plan adversely affected a plans beneficiary’s interest, but whether
the person was acting as a fiduciary (that is, was performing a fiduciary
function) when taking the action subject to the complaint.”)
are governed by the Employee Retirement Income Security Act. ERISA defines a
fiduciary as a person who: (i) exercises discretionary or discretionary control
with respect to the management of a retirement plan or exercises any authority
or control with respect to the disposition of plan assets, (ii)renders
investment advice for a fee with respect to money or other property of a
retirement plan, or, (iii)has any discretionary authority or responsibility in
the administration of the plan. 29 USC § 1002 (21)
See Rosen C. Klein Et. Al., Employee
Ownership in America: The Equity Solution (1986)
National Center for Employee Ownership, Largest
Study Yet Shows ESOPs Improve Performance and Employee Benefits, Articles,
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