INCOME TAX & TAX PLANNING

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EMPLOYEE STOCK OWNERSHIP PLANS (ESOPs)

 

Purchase of Shares in a Closely Held Company

 

An ESOP is a qualified retirement plan governed under ERISA whose funds must be invested primarily in employer securities, generally the common stock of the employer or a security resembling common stock.  ESOPs are defined contribution plans meaning that each individual participant in the plan has a separate account and plan contributions are determined by a formula stated generally as a percentage of the participant's salary.

 

In a properly designed transaction, the owners of a private company selling stock to an ESOP can defer taxation on their gains by reinvesting in the securities of other companies, so ESOPs are often used to purchase the shares of a departing owner.  The establishment of the ESOP provides the funding or a market for the owner's stock.  

 

Establishing an ESOP

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Upon the establishment of an ESOP, a company can contribute cash to buy stock from itself, contribute shares to the plan, or have the plan borrow money to buy shares. If the plan borrows money, the company makes ongoing contributions to the plan to enable the plan to repay the loan. The contributions to the plan are tax-deductible and employee-participants pay no tax on the contributions until they receive the stock when they leave or retire.  Both C and S corporations can establish ESOPs.  Earnings attributable to the ESOP's ownership share in S corporations are not taxable.

 

Employee Ownership and Company Performance

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ESOPs and employee workplace participation programs are often touted as providing employees with more incentive on the job. It has also generally been shown that companies that have ESOPs perform better than companies that do not, especially among closely held companies in the private sector.

 

ESOP Trustees and Duties

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All plan fiduciaries, including ESOP Trustees must know and follow their duties.  An ESOP Trustee must discharge its duties solely in the interest of the plan participants and for the exclusive purpose of providing benefits to participants and beneficiaries and for defraying reasonable expenses of administering the plan. An ESOP Trustee is required to conduct the affairs of the ESOP with the care, skill, prudence and diligence, under the circumstances then prevailing, that a prudent person acting in a like capacity and familiar with such matters would use in the conduct of an enterprise of a like character and with like aims. The ESOP Trustee must ensure that the ESOP pays or receives adequate consideration in a purchase or sale of employer securities that involves a party in interest. This is extremely important because a fiduciary that breaches its responsibilities, obligations or duties to the plan shall be held personally liable for any losses incurred.

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ESOPS and ESOP Trustees in Corporate Acquisitions

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When the target company in a corporate acquisition is owned in whole or in part by and ESOP, the transaction can be more complicated as a result of the ESOP's and ESOP Trustee's participation. A prudent ESOP Trustee will generally not want to participate in many provisions of a Stock Purchase Agreement that may be required of the individual shareholders.  Such examples would include 1) a "Purchase Price Adjustment" to the sales price of the ESOP stock that would be held in escrow for some period of time after the acquisition and that could potentially reduce the price paid for the stock and 2) the giving of representations and warranties that may more properly be required of individual shareholders and that could subject the ESOP to future liability.

 

The issues involved in tax planning and ESOP transactions can be complicated. An effective tax plan should not be. Contact us today to request a consultation with accomplished Charleston tax lawyer John Kachmarsky.