In the early 1960s, Mortimer Adler and Louis Kelso published the Capitalist Manifesto, a book outlining a way for American workers to get a stake in the companies they worked for. Adler and Kelso gained the ear of the chairman of the House Appropriations Committee. The result was legislation authorizing the Employee Stock Ownership Plan (ESOP), which incorporated a number of tax incentives to encourage its use.
The ESOP is sometimes used for the sale of stock by retiring owners of an insurance agency. For both sellers and buyers, it has a number of potential advantages over such strategies as buy-sell agreements or mergers with other agencies. Although legislation over the years has eliminated some of these advantages, the ESOP still can be a useful tool with substantial tax benefits under the right circumstances.
Advantages of a Leveraged ESOP
As a retirement plan qualified for favorable tax treatment by the Internal Revenue Service, an ESOP invests primarily in the stock of the employer. A leveraged ESOP uses outside financing to fund all or part of the sale.
With a leveraged ESOP, the employer and the ESOP borrow money from a bank, insurance company, or other financial company-to buy employer stock. This stock may be purchased from the retiring owner or owners. It enables the owners to cash out part or all of their interest in the agency immediately, rather than be paid off over time, as typically occurs under a buy-sell agreement. As the loan is paid off, the employees become the owners of the agency stock.
The corporation will be able to deduct for income tax purposes the entire payment it makes to the ESOP to repay the loan. This is a much better tax situation than the corporation or other purchaser would enjoy under a buy-sell agreement. A buyer of stock can't deduct principal payments, and might not be able to deduct interest payments either.
Another advantage of the ESOP is that the selling shareholder can roll over the payment into certain other securities, and postpone the tax on the capital gain until the securities are sold. For this, the ESOP must own at least 30% of the stock of the employer corporation immediately after the sale, and the seller must own the stock for at least three years.
In the past, certain institutional lenders (including insurance companies) were able to deduct 50% of the interest paid on the ESOP loan for income tax purposes. Some ESOPs also generated tax credits in addition to deductions. Also, there used to be certain estate tax benefits for sales by an estate to an ESOP, These benefits have been eliminated-but the remaining benefits can be substantial.
Ideally, in a leveraged sale, the ESOP will enable a shareholder to sell his interest in an insurance agency for cash rather than deferred payments, reinvest the gain in listed securities, and defer income taxes on the gain on the listed stock until it's sold. The corporation will be able to deduct all payments of principal and interest on the loan.
Tax changes in 1997 now allow ESOPs and other tax-exempt organizations to be shareholders in S corporations. This change may make it easier for agents to establish ESOPs as part of a strategy for acquiring the agency's stock. In particular, use of an S corporation may make it easier for an agent buying agency stock outside the ESOP to deduct interest payments on the purchase. These purchases of stock outside the ESOP are often needed if the buyers are to retain control of the agency.
Disadvantages of a Leveraged ESOP
With these advantages, why isn't the ESOP used more frequently? The answer: There are some significant potential drawbacks that make it inappropriate in the majority of cases.
- Among the disadvantages are the legal and other costs of the transaction, which are much greater than the costs of preparing a simple buy-sell agreement and related documents.
- Initially, there are costs in preparing the plan and qualifying it with the IRS, of dealing with the lender in obtaining the loan, and of obtaining an appraisal of the stock.
- There are also yearly ongoing costs for maintaining the plan records and preparing required filings, and for the required yearly appraisal of the stock. Only a fairly large transaction can bear these costs. Many of these costs are unnecessary or inflated in my view, but they're typically imposed by the lenders and their lawyers. An agency with a reasonable lender and lawyer should be able to reduce the costs substantially.
- Another disadvantage is the downstream cash flow requirements for the employing company as its employees begin to retire or reach retirement age. These employees have a right in certain circumstances to ask that their ESOP holdings in employer stock be repurchased by the employer or diversified. This can lead to substantial cash payments by the employer corporation, in addition to any payments it may still have to make to fund the ESOP loan. This exposure can be reduced by providing for repurchase over time. However, careful financial calculations should be done by the corporation and the remaining owners before entering into an ESOP.
Conclusion
A leveraged ESOP is most appropriate for internal perpetuation plans. The holders of a substantial block of the shares of a medium-size insurance agency, who do not have a potential sale or merger partner but who do have an insurance company or other lender willing to handle the loan on a reasonable basis, may find it an ideal solution.
I know of at least one insurance agency that swears by ESOPs. I know of other instances where the parties felt that ESOPs did not work as expected.