An employee stock ownership plan (ESOP) can facilitate the transfer of a business to the owner’s children or employees over a period of years in a tax-advantaged way. However, the IRS recently issued a statement warning businesses about a range of compliance issues related to ESOPs and announcing plans to ramp up compliance enforcement. The IRS has identified numerous issues, such as improper valuation of employer stock, prohibited allocation of shares to disqualified persons and failure to follow tax law requirements for ESOP loans, causing the loans to be prohibited transactions.

In light of this warning, business owners who are interested in pursuing an ESOP should seek the advice of business valuators and other professional advisors to ensure compliance with the rules. Here’s some critical information when deciding whether an ESOP is the right strategy for a particular business.

Differences from buyouts

An ESOP is a qualified retirement plan that invests mainly in company stock. ESOPs are subject to the same IRS and U.S. Department of Labor (DOL) rules as other qualified retirement plans, such as 401(k) plans, including minimum coverage requirements and contribution limits.

Generally, ESOP distributions to eligible employees are made in stock or cash. For closely held companies, employees who receive stock have the right to sell it back to the company (exercising “put” options, or an “option to sell”) at fair market value during certain time windows.

While an ESOP involves transferring ownership to employees, it’s distinguishable from a management or employee buyout. Unlike a buyout, an ESOP allows owners to cash out and transfer control gradually. During the transfer period, owners’ shares are held in an ESOP trust and voting rights on most issues (other than mergers, dissolutions and other major transactions) are exercised by the trustees, who may be officers or other company insiders.

Mandatory valuations

The fair market value of the sponsoring company’s stock is critical, because the DOL specifically prohibits ESOPs from paying more than “adequate consideration” when investing in employer securities. In addition, because employees who receive ESOP shares typically have the right to sell them back to the company at fair market value, the ESOP essentially provides a limited market for its shares.

The Employee Retirement Income Security Act of 1974 requires trustees to obtain business valuations by independent professionals to support ESOP transactions. Specifically, a valuation is needed:

• When the ESOP initially acquires shares from the company’s owners, and
• Each year thereafter that the corporation makes contributions to the plan.

The owners also may decide to obtain an informal valuation before the ESOP is set up to help evaluate whether it’s a feasible exit strategy.

Costs and limited availability

ESOPs offer substantial benefits. But there are some drawbacks. In addition to administrative and compliance costs incurred by qualified retirement plan sponsors, there are costs associated with annual stock valuations and the need to repurchase stock from employees who exercise put options. It’s also important to consider the potential negative impact of ESOP debt and other expenses on the company’s financial statements and bonding capacity.

Another disadvantage is that ESOPs are available only to C and S corporations. The National Center for Employee Ownership estimates that more than half (55%) of ESOPs are in S corporations. But they have different rules than C corporations when it comes to ESOP contributions and tax treatment. With proper planning, income passed through to shares held by an S corporation’s ESOP escapes federal — and in some cases, state — taxes.

Limited liability companies (LLCs), partnerships and sole proprietorships must convert to the corporate form to take advantage of an ESOP. This raises a variety of financial and tax issues.

(This is Blog Post #1463)