Published Spring 2011 in Boston Bar Association’s Business Law Section Newsletter SES Advisors’ Rob Edwards coauthored this article, which summarizes the special treatment of ESOPs, explains how leveraged ESOPs work and discusses key ESOP valuation concepts that apply to ESOP transactions.

1. Volume 6
Spring 2011
Business Law Section
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Spring 2011
Volume 6

2. ESOPs in Business Succession Planning
By Robert W. Edwards and Gregg Hamilton-Piercy
Introduction
An Employee Stock Ownership Plan (“ESOP”) is a tax qualified retirement plan which is designed to invest primarily
in stock of the sponsor corporation. Under §4975 of the
Internal Revenue Code of 1986, as amended (the “Code”)
and §§406 and 408 of the Employee Retirement Income
Security Act of 1974 (“ERISA”), ESOPs are the only type
of retirement plan that can borrow money from (or obtain
loans guaranteed by) a party in interest (an “exempt loan”).
This enables an ESOP to use financial leverage to make
substantial purchases of company stock and, in combination with significant ESOP tax benefits, explains why ESOPs
are often used to facilitate internal ownership transitions
of privately held companies. At the same time, a large volume of overwhelmingly positive ESOP research shows that
ESOP companies are more productive and profitable than
their non-ESOP counterparts. The National Center for Employee Ownership estimates that ESOP companies grow 2
to 3% faster than their non-ESOP counterparts, enjoy lower
employee turnover and achieve 2.5% greater productivity.
Notwithstanding the substantial tax and financial benefits
of ESOPs and the empirical research demonstrating that
ESOPs increase productivity, ESOPs are not as prevalent as
one would expect, perhaps because the legal framework is
complex and not well understood. Loren Rodgers, recently
appointed as Executive Director of the National Center
for Employee Ownership, estimates that there are about
10,500 ESOPs in the United States, more than 95% of
which are sponsored by nonpublic companies. The Small
Business Jobs Protection Act of 1996 (“SBJPA”), allowed
ESOPs to own stock of S corporations. Beginning in 1998,
ESOP-owned S corporations were not taxable on their allocable share of the company’s earnings. In addition, ESOPs
are wholly (or partially) exempt from state income taxes
in most states. Only fifteen years after enactment of the
SBJPA, Rodgers estimates that there are more than 3,500
majority or wholly owned S corporation ESOPs.
Steven F. Freeman, Effects of ESOP Adoption and
Employee Ownership: Thirty Years of Research and Experience,
working paper #07-01 (University of Pennsylvania 2007), posted at
ScholarlyCommons@Penn http://repositoryupenn.edu/od_working_
papers/2.
Corey Rosen, Research on Employee Ownership Corporate
Performance and Employee Compensation, National Center for
Employee Ownership, http://www.nceo.org/main/article.php/id/3/.
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Spring 2011 Volume 6
The following sections summarize the special treatment of
ESOPs, explain how leveraged ESOPs work and discuss key
ESOP valuation concepts that apply to ESOP transactions.
Special ESOP Qualification Requirements
Most ESOPs are stock bonus plans that satisfy additional
ESOP qualification requirements in §§401, 409 and 4975
of the Code.
Qualifying Employer Securities - Code §409(l)
An ESOP must be designed to invest primarily in “qualifying employer securities” which means generally 1) voting
common stock of the employer (or another company in the
same controlled group of corporations) with a combination
of voting and dividend rights equal to the highest class of
common stock, or 2) preferred stock convertible at any
time into common stock at a conversion price which is
reasonable at the date the ESOP acquired the employer
securities.
ESOP Put Option - Code §409(h)
ESOP participants must generally be given the right to
demand a distribution of their account balance in the form
of qualifying employer securities. However, if the company
is an S corporation, or its bylaws or charter restrict ownership of substantially all qualifying employer securities to
employees or a qualified retirement trust, distribution may
be made in cash or in employer securities that are subject
to immediate repurchase by the employer. Distributed
shares must contain a put option obligating the employer
to repurchase the shares at a fair value in the year of distribution and again in the following year. If employer securities are distributed in a total distribution, payment under
the put option may be made over a period not in excess
of five years (longer if the shares are valued at more than
$985,000), but the employer must provide adequate security and pay interest at a reasonable rate on the unpaid
balance.
ESOP Distributions – Code §409(o)
Unless a participant otherwise elects, ESOP distributions
on account of normal retirement, disability or death must
begin not later than one year after the year in which the
participant separated from service; distributions to participants whose employment is terminated for other reasons
must commence not later than the sixth plan year after the
year in which the participant separated from service. An exception allows distribution of employer securities acquired

3. ESOPs in Business Succession Planning By Robert W. Edwards and Gregg Hamilton-Piercy
with the proceeds of an exempt loan to be deferred until
the year after the year in which the exempt loan is repaid.
Annual Appraisal – Code §401(a)(28)(C)
Nonpublicly held employee securities held in an ESOP
must be appraised annually by an independent appraiser.
ESOP Diversification – Code §401(a)(28)(B)
Participants age 55 or older with ten or more years of participation in the ESOP must be given the right to diversify
up to 25% of the employer securities that have ever been
allocated to their ESOP account. Diversification must be
offered annually for five years; in the sixth and final year of
statutory diversification the elective percentage increases
to 50%. An ESOP may satisfy the diversification requirement by distributing cash (or qualifying employer securities subject to immediate repurchase), by offering at least
three investment options under the plan, or by transferring
the diversified funds to another employer sponsored plan
that allows for participant investment direction.
ESOP Tax Benefits
ESOP Rollover – Code §1042
This allows a selling shareholder (other than a C corporation) to defer recognition of capital gain on the sale of
“qualified securities” to an ESOP if the proceeds are rolled
over and reinvested in “qualified replacement property”
within a fifteen month window beginning three months
before the ESOP sale and ending twelve months after the
sale. “Qualified securities” means C corporation stock
that has been held by the selling shareholder for at least
3 years, and was not acquired through exercise of an
employment-related option or a compensatory transfer to
which Code §83 applied. Code §409(n) restricts the ability
of the seller, certain family members and 25% or greater
shareholders to participate in ESOP allocations after a
rollover sale. “Qualified replacement property” generally
means securities issued by an active domestic operating
corporation that satisfies certain passive income limitations, and were not issued by the employer or a member
of the same controlled group of corporations. The qualified
securities purchased by the ESOP in a rollover transaction
are subject to a 10% penalty tax payable by the employer
if they are sold or otherwise disposed of within three years
after the ESOP purchase, except for normal distributions
on account of retirement, death or disability.
ESOP Deductions – Code §404
ESOP leveraged loans receive very favorable treatment.
Under Code §404(a)(9)(A); a C corporation may deduct
ESOP contributions used to repay an exempt loan up to
25% of the covered compensation of participating em-
ployees. Under Code §404(a)(9)(B), contributions used to
repay interest on an exempt loan are deductible without
limitation. The Code §404(a)(9) rules applicable to deductions for leveraged ESOP contributions apply in addition to
allowable deductions for contributions to other employer
plans.
Under Code §404(h) reasonable dividends on C corporation stock that are applied to repay an exempt loan or are
paid or passed through to participants in cash are deductible. However, if dividends on allocated shares are used
to repay the loan, employer securities with a fair market
value at least equal to the dividends paid on the allocated
shares must be allocated to participants’ accounts.
Expanded Annual Additions - Code §415(c)(6)
Code §415(c)(6) increases the dollar value of the annual
additions that may be allocated to participants’ accounts
in C corporation ESOPs with an exempt loan deductible
under Code §404(a)(9). If not more than one-third of the
employer contributions are allocated to highly compensated employees, forfeitures and interest on the leveraged
loan are not included as annual additions.
S Corporations
S corporation stock sales are not eligible for rollover treatment, or for the increased tax deductions and allocations
that apply to C corporations. S corporations are also subject to complex anti-abuse rules set forth in Code §409(p)
that effectively limit the use of ESOPs in S Corporations
with fewer than 20 employees. Still, the growth of ESOPsowned S corporations has been dramatic. A primary reason is that the tax savings enjoyed by S corporation ESOPs
can enable a 100% ESOP buyout to be completed within a
compressed 5-7 year timeframe.
Leveraged ESOPs
Most ESOPs established to finance ownership transactions
are leveraged, which means they use an exempt loan to
acquire a significant ownership stake in the company. In a
“traditional” ESOP transaction (see the Figure 1 illustration
on next page) the lending bank extends credit to the company, which in turn reloans the proceeds to the ESOP. For
fiduciary reasons, it is preferable to break the ESOP loan
into two loans; the “outside” loan from the lender to the
company followed by an “inside” loan from the company to
the ESOP. In this structure, the inside loan is the exempt
loan. The note from the ESOP is secured by a pledge of
the acquired securities. The loan repayments illustrated in
Figure 2 on next page could be made from either employer
See PLR 200436015.
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4. ESOPs in Business Succession Planning By Robert W. Edwards and Gregg Hamilton-Piercy
contributions or deductible dividends on the qualifying employer securities acquired with the exempt loan. Figure 3
on next page shows a typical transaction resulting in 100%
ownership of an S corporation. Leveraged ESOP transactions often require seller financing, which is usually in the
form of a subordinated note, sometimes accompanied by
warrants. Because an ESOP sale of S corporation stock is
not eligible for a Code § 1042 rollover, the company often
redeems the shares and then resells them to the ESOP;
in other respects the transaction is similar to the typical
leveraged ESOP shown in Figure 1.
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5. ESOPs in Business Succession Planning By Robert W. Edwards and Gregg Hamilton-Piercy
ESOP Valuations
An ESOP trustee must obtain an independent valuation
from the ESOP appraiser to determine that the ESOP
has not paid more than “adequate consideration” for the
shares acquired in an ESOP transaction in order for the
purchase to be exempt from the prohibited transaction
rules of ERISA and the Code. Company valuation is critical
to the establishment and maintenance of an ESOP; failure
to properly value employer securities held in the ESOP can
lead to prohibited transaction taxes under Code §4975,
penalties under ERISA §502(l) and substantial administrative and compliance costs.
Consider the following illustration where a newly
formed leveraged ESOP purchases a 40% ownership
interest of the common stock in the sponsoring company:
Market Value of Invested Capital
Less: Existing Debt
Less: ESOP Related Debt
Plus: ESOP Tax Shield
Pre -ESOP
$
75,000,000
(20,000,000)
-
Post-ESOP
$
75,000,000
(20,000,000)
(22,000,000)
3,000,000
Market Value of Equity
$
55,000,000
$
3,000,000
In subsequent annual valuations, it is also important
to consider how the sponsoring company’s capital
structure may affect cash flows and may limit the
company’s access to additional debt to help fund
future growth.
Beyond typical best practices in business valuation generally, there are some unique issues specific to ESOPs that
need to be considered by the valuation professional:
• ESOP Debt and Associated “Tax Shield”: After a
leveraged ESOP is established, the sponsoring company’s balance sheet now includes the debt associated
with the purchase and, consequently, the company’s
post-transaction equity value will be lower. However,
the future benefits associated with the fact that the
ESOP debt is fully deductible has a partially offsetting
positive impact on the value of the ESOP owned company. As the debt is repaid, the “tax shield” benefit
incorporated into the valuation is reduced.
• Price Protection for Subsequent ESOP Transactions: Many ESOP companies are initially set up with
less than 100 percent ownership, and a second ESOP
transaction is often consummated at a later date. This
multi-tiered process can be a challenge because the
ESOP is then structured with two tranches of stock
purchased at two different valuations. Furthermore,
the debt associated with the second tranche dilutes
Adapted from Robert F. Reilly and Robert P. Schweihs,
Willamette Management Associates Guide to ESOP Valuation and
Financial Advisory Services (2005).
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6. ESOPs in Business Succession Planning By Robert W. Edwards and Gregg Hamilton-Piercy
the value of the shares acquired with the first tranche.
ESOP plan documents are often amended to provide
anti-dilution protections for the first tranche ESOP participants. These price protection provisions typically
provide protection for a limited period by obligating
the company to purchase distributed shares at a value
determined without respect to the debt incurred in the
second tranche, and need to be taken into consideration as part of the ESOP valuation.
• Discount for Lack of Marketability: Stock in a
closely-held company is by definition an illiquid security and subject to a significant pricing discount for lack
of marketability. However, the put option on distributed ESOP shares effectively creates a market for the
shares, thereby reducing the marketability discount
and increasing the value of the shares.
• Repurchase Liability: Although the repurchase
obligation reduces the marketability discount on
ESOP shares, this obligation is a future liability of the
sponsoring company. As time passes, this repurchase
liability becomes more and more important as 1) the
ESOP shares vest, 2) the value of the ESOP company
increases over time and 3) participants begin to age
and retire. If not properly planned for, this repurchase
obligation may put a strain on the company’s future
cash flows and adversely affect annual valuations.
• ESOP Contribution Expenses and/or ESOP Dividends: ESOP contributions and dividends used by the
ESOP to pay an exempt loan are classified as an ESOP
contribution expense on the sponsoring company’s
income statement. To the extent they exceed normal
retirement benefits, the appraiser must reduce or normalize these ESOP expenses in the valuation of the
company.
• ESOP Setup Expense: Legal, valuation and related professional fees associated with establishing
an ESOP can be substantial. These setup costs are
typically adjusted to be amortized over the life of the
ESOP loan.
• Annual Share Value Volatility: ESOP shares are
considered long-term retirement benefits to the ESOP
participants. Accordingly, the appraiser needs to incorporate a long-term investment horizon in the valuation
process without compromising professional standards.
This may result in some smoothing of value from year
to year.
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Spring 2011 Volume 6
Characteristics Of Good ESOP Candidate
Companies
Not all companies are good candidates for ESOPs. For
example, family owned companies with a succession plan
that continues to include a legacy of family ownership may
not want to consider an ESOP. Companies with some or all
of the following traits may benefit from consideration of an
ESOP structure:
1. Ownership Profile: The current owners are committed to supporting the ownership transition and are
flexible enough to offer some seller financing.
2. Cash Flow History: The sponsoring company has
a history of significant cash flow to support additional ESOP debt. Typically a minimum of $400,000
to $500,000 in historical pre-tax profits, adjusted
to reflect normal executive compensation, is a good
starting point.
3. Staff: The sponsoring company has enough staff
to have an active upper management level and preferably a second-tier management team in place.
4. Value vs. Payroll: The company value to total payroll ratio is low enough to make the deal work. If the
company is valued at $100 million with a payroll of
just $2 million, it may be difficult to service ESOP debt
through company contributions, even if dividends (or S
distributions) are used for this purpose.
5. Growth expectations: The sponsoring company
has reasonable growth prospects with respect to geographic markets served, expanding market share and
the anticipated general growth of the industry. Companies with poor growth prospects, and companies with
explosive growth potential are doubtful candidates;
the former for obvious reasons, the latter because
sudden dramatic increases in a company’s repurchase liability can make financing the repurchase
liability problematic.
6. Costs: Setting up an ESOP can be a less expensive liquidity option than engaging an investment bank
or receiving private equity financing. However, a sponsoring company should have adequate wherewithal
to cover the fees of the ESOP’s professional advisors
(legal, valuation and in some cases, an independent
fiduciary) as well as its own. Although fees can vary
greatly, expect a plain vanilla leveraged ESOP transaction to cost between $80,000 and $120,000 (or
more if an independent fiduciary is engaged), and that

7. ESOPs in Business Succession Planning By Robert W. Edwards and Gregg Hamilton-Piercy
ongoing annual valuation and administrative fees will
range from $12,000-$20,000.
7. Existing Benefit Plans: Companies with an existing profit sharing or other employee benefit plan may
be able to divert future payments to the ESOP without
incurring additional employee compensation costs. In
some cases, accounts in another qualified plan can be
electively transferred directly into the new ESOP and
used to fund the ESOP purchase.
8. Cultural Fit: A successful ESOP implementation
hinges on a transition from a company of employees
to a company of owners. Although difficult to assess, a
good ESOP candidate exudes an eagerness to embrace this cultural shift. An ongoing ESOP communication plan will help build a solid ownership culture in
the new ESOP company.
Conclusion
As the baby boom generation reaches retirement age,
ownership of more and more closely held companies will
change. For a business owner considering ownership transition, ESOPs offer a number of advantages:
• Significant tax and financial benefits
• The ability to finance an internal ownership transition for the benefit of current employees
• ESOP sales can be structured in stages, leaving
the owner in control of the business until the ownership transition is completed
• An ESOP can enhance the company’s future
growth and profitability when a successful employee
ownership culture has been established.
For these reasons, business advisors need to be familiar
with the uses and applications of ESOPs as a powerful
tool for business succession.
Spring 2011
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