A checklist for a business owner to determine if an ESOP might be a good fit for his company.

1. Is Your Company or Client a Good Candidate
for an ESOP?
Three Scenarios and a Checklist
January 29, 2015
Employee stock ownership plans (ESOPs) are established by privately held companies for
many reasons, primarily driven by their tax advantages. ESOPs are tax-qualified retirement
plans that generally must be offered to all employees, to meet non-discrimination rules. This
article focuses on scenarios in which your company or perhaps your client – assume a privately
held company - should consider an ESOP. In these scenarios, an ESOP can be an effective
tool to achieve your company’s or client’s objectives.
► Scenario #1 - The Founder Exit Strategy. Business owners who are ready to transition
ownership on a tax-favored basis can sell their stock in a C corporation to an ESOP and
defer all capital gains tax by reinvestment in a portfolio of U.S. publicly traded securities,
including high credit rated floating rate notes – “qualified replacement securities” in a Code
section “1042 rollover” transaction. Founders who are planning to retire, with a
management team interested in acquiring the business (but without the liquidity or the
appetite for taking on considerable personal debt), may profit from a tax-deferred sale to an
ESOP. Review our Checklist and see if your company or client is a good ESOP candidate.
► Scenario #2 – Refinancing Existing Debt using Pre-tax Dollars. An ESOP borrowing
from a bank to acquire shares of stock in the company can re-pay both principal and interest
on the loan using pre-tax dollars contributed by the company. Example: To repay a
$10,000,000 loan without an ESOP would require $15,384,615 of pre-tax profits
($10,000,000 divided by (1 minus the 35% tax rate)). The ESOP reduces the amount of
pretax cash flow required to pay off debt by 65%.
► Scenario #3 – S Corporation Status with a 100% ESOP Owner. An S corporation
establishing an ESOP will not pay any income taxes on its profits that flow through to the
ESOP (a tax exempt retirement plan). Many S corporation ESOP sponsors transfer 100%
ownership to the ESOP so they operate without the burden of paying any income taxes on
their profits. At times, a C corporation can engage in the “leveraging” transaction providing
1042 “rollover” treatment for the founders, as described above, and subsequently the
company converts to S corporation status to achieve the tax advantages of an ESOP S
corporation.
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2. ESOP CONSIDERATIONS Page 2
CHECKLIST: Is Your Company or Client a Candidate for an ESOP?
Yes/No? Issue Implication
Does the company expect to pay
substantial federal income taxes?
The business will profit from repaying
ESOP debt with pre-tax dollars. The
business may consider electing S
corporation status, possibly post leveraging
transaction with an ESOP so its earnings
are tax-free.
Does the company have a stable
workforce, with a payroll adequate to
support an ESOP?
ESOP contributions to pay debt service
can be deducted up to 25% of payroll (to
amortize the principal), plus all interest is
deductible.
Given the percentage of stock to be
sold, can the company finance
additional debt based on its cash flow
and balance sheet? Is the seller
willing to provide a portion of the
financing?
Founders may need to offer seller financing
for all or part of the ESOP sale. Many
leveraging transaction include both bank
(senior) debt and seller (subordinated)
debt.
Is the founder’s anticipated valuation of
the company reasonable?
See below – will the founder get the best
price for his business by selling to an
ESOP? Consider the tax advantages of
selling to an ESOP using a 1042 rollover
sale of stock in a C corporation.
Is there a strong management team in
place to succeed the founders?
The ESOP buy-out can be structured with
a “management incentive plan” so that top
managers share in ownership with the
ESOP.
Are the founders willing to share
ownership with employees and are
they supportive of an employee
ownership culture?
While ESOP companies are not required to
share financial information with employees,
the most effective ESOP companies have
an “ownership culture” emphasizing
teamwork and transparency.
Will a founder get the best price for the business by selling to an ESOP? Good question.
The ESOP will pay what an appraiser determines a financial buyer will pay (such as a private
equity investor), not what a strategic buyer would pay. The ESOP sale may allow the founder to
defer any capital gains tax. The ESOP Trust can pay up to “true” fair market value for the
beneficial value of the shares for the employees’ retirement accounts. There is some
discounting of the price for the cost of capital and risk of the forecast, but not for a profit on the
purchase price. Financial buyers typically must provide a profit to their investors on the price
paid above the cost of capital and will price the transaction considering an appropriate risk
factor for their investment, so they pay less than the “true” fair market value. The price paid by
the ESOP has no purchase price discounting to make a profit on the transaction and can have
lower costs of capital using seller notes and first secured bank debt. Also, an ESOP typically
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3. ESOP CONSIDERATIONS Page 3
pays cash, there is no earnout, and although there are significant professional fees incurred in a
leveraging transaction, there is no traditional broker fee to pay on the transaction.
Expert Assistance Required. ESOP transactions are highly technical and require the
assistance of counsel and financial professionals who know the rules. Wilkins Finston Friedman
(“WiFi”) is well versed in these rules and often acts as ERISA counsel in ESOP transactions on
behalf of the independent ESOP “transactional” trustee - the fiduciary who must assure that an
ESOP transaction meets the high fiduciary standards of ERISA. Alternatively, WiFi often acts
as ERISA co-counsel to the company, to assist the company’s counsel in drafting ESOP
documents, obtaining IRS approval, and assuring compliance with tax and regulatory
requirements. In such cases, the “transactional” trustee selects other, independent counsel to
protect the interests of the ESOP and its participants and beneficiaries. If your company or
client is a good candidate for an ESOP, WiFi will partner with you to assure that the transaction
is planned and executed in a manner that meets IRS and ERISA requirements.
Please contact Linda Wilkins LWilkins@wifilawgroup.com, Felicia Finston
FFinston@wifilawgroup.com, Jay Friedman JFriedman@wifilawgroup.com, Misty Leon
MLeon@wifilawgroup.com, Diane Cooper DCooper@wifilawgroup.com, Kathy Kull
KKull@wifilawgroup.com, or Laura Irani LIrani@wifilawgroup.com if we can assist you in an
ESOP feasibility study for your company or client. This information is designed to provide
general information regarding ESOP transactions and should not be considered legal advice,
nor does it create a lawyer-client relationship.
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