FACT: Estimates indicate that, as of the millennium (2000 A.D.), $6 trillion of personal wealth consisting mostly of private family businesses will transfer over the next decade without an immediate market. If you want liquidity and believe that your employees contributed to your company’s success and should be rewarded with company ownership, then an Employee Stock Ownership Plan (ESOP) may be your solution.
Legislated as part of the Employee Retirement Security Act of 1974 (ERISA), an ESOP is a qualified employee defined contribution plan designed to encourage broad based employee ownership by investing primarily in the stock of a private sponsoring company. The sponsoring company shareholders, in exchange for contributing their stock to an ESOP, achieve liquidity and transition. Meanwhile, the sponsoring company shareholders receive several tax advantages by creating a market for the contributed shares. On the other hand, the employees or plan participants, receive stock and an immediate market (using put options or the right to sell) for their shares once vested. ESOPs not designed for broad based employee ownership are not in the spirit of the law, are probably scams and risk scrutiny by the Internal Revenue Service (IRS) and the Department of Labor (DOL).
Under current regulations, the IRS and DOL require a valuation of ESOP shares by a qualified valuator without a personal or financial interest in the valuation. The valuation should be performed on behalf of the ESOP trustee, who must ensure that the stock bought by the ESOP is at “fair market value”, which is the price the property would sell under existing market conditions for such property as established in arms-length negotiations between knowledgeable and independent parties. It is illegal for an ESOP to pay more than the fair market value for the stock it purchases.
ESOP valuations facilitate the decision making process by the shareholders, the company management and their professional advisors: attorneys, accountants, lenders and trustees. The stock value, the interest being valued and the transaction structure are key components in the decision making process. The shares of a vested employee without a controlling ownership interest separating from the company are repurchased using the annual valuations. Whereas, the shares of a vested employee with a controlling ownership interest separating from the company are repurchased using valuations as of the date of the repurchase.
Vested employees have the right to ‘put’ the company shares held in their qualified plan accounts to the company and the company must repurchase the shares at the current fair market value upon death, permanent disability, retirement or termination from service. The employee, however, must wait until the following plan year before being paid, thereby retaining the investment risk during this waiting period. Companies that do not provide adequate funding or security for the ‘put’ or repurchase liability risk losing their tax advantages. A promise to pay the repurchase liability by the company, even if secured by its full faith and credit, is not seen as adequate funding or security by the IRS and DOL.
The repurchase liability is usually small during the initial years of an ESOP. As the ESOP matures, the size of the repurchase liability grows as employee account balances, vesting percentages and stock values increase. Actuaries, using computer models and labor tables, estimate the repurchase liability and cash needed over twenty years or a period sufficient to reflect anticipated changes in variables such as age and gender of participants, company growth expectations, distributions due to age and time in the plan, terminations, disability, retirement, death and the amortization of the ESOP loan.
If a company does not immediately and continuously fund the repurchase liability estimated by an actuary, it risks not having the cash needed to fund the “puts” as they are exercised. The company also risks underfunding if it funds its repurchase liability without an actuarial study. The ability of a company to honor the “put” provision is critical to the evaluation of the discount for lack of marketability. Companies can minimize the discount for lack of marketability by having adequate funding or security to cover the “puts”. Discounts for lack of marketability for ESOP shares have ranged between 10% and 40%.
Funding the Liability
There are several methods for funding the repurchase liability. The Pay-As-You-Go and Stock Option methods do not continuously fund the ongoing repurchase liability and therefore the company does not receive tax advantages. In the Sinking Fund method, the funds are subject to the claims of creditors and the investment growth within the fund is subject to current taxation. As the fiduciary of the ESOP, the trustee may not purchase additional stock that is not in the best interest of the employees even if funds were available using the S Corporation and Recycling methods. The Qualified Plan method severely limits the purchase of company stock in a 401(k).
Despite the cost of insurance, the Corporate-Owned Life Insurance method has several benefits: tax-deferred investment growth within the policy’s separate account (variable life policies), cash value and death benefits to pay the exercised ‘puts’, cash value asset is nearly protected from creditor claims, professional management of the separate account and insurance company or third party guarantees. This method also meets the definition of adequate funding or security.
Other than in ESOPs or other tax-favored maneuvers, valuations by a business valuation analyst are important in financial, tax and litigation matters.
The preceding article is intended as general information and should not be considered legal, tax, accounting or other expert advice. As the author, I represent that neither the information nor its impact is comprehensive. If legal, tax, accounting or other expert advice is required, please use a qualified and competent professional.