As pensions at large corporations are going the way of Smith-Corona typewriters, options still exist for small private companies to gain tax advantages while providing retirement money for their employees.
In the 1970s Congress created leveraged employee stock ownership plans, or ESOPs. These are qualified plans, meaning that the employer can make contributions on a tax-deductible basis and those contributions are tax deferred for the employee — until the employee takes them as distributions at times specified by the law.
Attorney Gary Young of Herrick Feinstein will present “Using ESOPS Strategically in Business,” on Thursday, September 10, at 4:30 p.m., at the Wilshire Grand Hotel in West Orange. Cost: $179. Visit www.njicle.com.
Here’s how a leveraged ESOP works: Say the owner of XYZ Corporation, a closely held business worth $20 million, agrees to set up a qualified plan and a trust associated with it. The trust will buy up to 49 percent of the shares for the employees.
In this example, say that the trust buys the maximum amount, at a cost of close to $10 million. The plan takes out a loan and buys the shares, and the employer commits to paying off that loan over several years. In this case, the employer will pay off the $10 million loan over, say, seven years — thereby contributing over $1 million a year. In comparison with plans like a 401k, the entrepreneur is making a far more substantial commitment to the plan, says Young.
From the employee perspective, he owns shares in the trust, which ultimately constitute his pension. “When it’s time for employees to retire,” says Young, “there are provisions for liquidating the shares and providing liquidity to pay the pension. The trust pays the pension.”
Leveraged ESOPs provide entrepreneurs with flexibility, allowing them to pursue a variety of options in the present and future:
Diversifying investments. “If an entrepreneur with a successful company is making a lot of money and is wise person,” says Young, “one of the things he should understand is that you don’t want to have all your eggs in one basket.” With an ESOP he can take some eggs out, using the proceeds from the sale of the 49 percent and then deferring recognition of his gain by buying qualifying U.S. securities. Now the entrepreneur has a diversified portfolio, owning 51 percent of XYZ Corporation as well as 49 percent in shares of IBM, Apple, and whatever.
Taking the company public. Say that seven years hence, the entrepreneur has paid off the loan and is ready to retire and cash in his chips. “One way the entrepreneur can do this is take the company public,” says Young. “He sells the other 51 percent he owns, and the ESOP ends up selling its shares in the IPO, and everyone is happy because they have realized a nice multiple. It is beneficial to the employees and to the entrepreneur.”
Selling out to the ESOP. If the entrepreneur does not want to go through the significant expense of an initial public offering, he can sell the rest of the stock to the plan and convert it to an ESOP. “The employees are happy that they own their company,” says Young. “All the profits of the company are not taxed because an ESOP is a qualified plan, where investment income is not taxable. Not only do the employees have an appreciation in value but the profits of the company are going into their pension accounts.”
Buying back the shares. “If the entrepreneur has done an ESOP and has a change of heart — he thought it was a good idea but later wants the family to continue in the business — he can buy back the shares and take it private again,” says Young. The employees, of course, get money in exchange for their shares.
Selling, but not immediately. An owner who is reaching a plateau of success and needs to decide where to take the company next, but is not yet ready to sell, can use leveraged ESOP as a middle ground between going public or taking it private.
Young grew up in Paramus. He graduated from the University of Pennsylvania in 1970 and from Brooklyn Law School in 1974.
After a couple years with a New York law firm he started his own practice, where he wrote pension plans and submitted them to the IRS and also developed a general corporate practice, including tax issues, employment law, and qualified plans.
Caveats. Any company considering an ESOP should be making money, have a predictable income, and have a good number of employees who can participate in the ESOP. The company will also need a loan from a bank, and not many banks are lending now.
Any entrepreneur who decides to do an ESOP must take great care putting it in place. “Anytime you are dealing with a pension plan,” says Young, “if you don’t do it right and observe all requirements and fiduciary responsibilities, you will have a lawsuit and you will probably lose. ”
An ESOP can also be pricey to set up. You have to make sure the value you place on the shares is solid and defensible, which means that you wil need valuation experts as well as someone to design the plan. Also necessary will be lawyers.
“That being said,” observes Young, “in the right situation it is very justified and because of the benefit that everyone involved derives from it, it can be a very happy thing for all.”