Employee stock ownership plans, commonly referred to as “ESOPs”, can provide substantial benefits to employees. Asa result, corporations that sponsor ESOPs may profit from enhanced employee productivity. In addition, ESOPs can be used to meet the needs of corporations and their owners for financing and liquidity. Because of these and other advantages that can be obtained from ESOPs, Congress has enacted important tax incentives for the creation of ESOPs. All parties to an ESOP transaction can obtain substantial benefits.

Tax advantages arise in these ways:

The Business Owner as a Seller. If shareholders of a private company sell 30 percent or more of their stock to an ESOP and satisfy certain other requirements, they can defer tax on the sale proceeds as long as the proceeds are reinvested in certain qualified investments. Thus, ESOPs enable business owners to create tax-advantaged liquidity; and they can be used to facilitate a transfer of ownership without a forced sale of the business.

The Company as Sponsor. Companies that sponsor ESOPs may deduct the value of their contributions from their tax liability. In addition, if a company uses an ESOP to borrow money, the company can deduct the principal payments it makes on the loan, as well as the interest. Moreover, by directly linking employee performance and rewards, an ESOP can lead to increased productivity and enhance the sponsoring company’s ability to withstand the threat of foreign and other competition.

The Employees as Buyers. Employees who acquire all or part of “their” company through an ESOP gain an opportunity to build wealth by holding stock in their company, without having either to buy the stock or to pay current taxes on their benefits, and without risking personal liability.

How can you sum up all of these benefits? . . . TAX MAGIC!

HOW ESOPS WORK

A. WHAT IS AN ESOP?

Welcome to the wonderful world of ESOPs.

At first glance, ESOPs may seem complex and intimidating. But the basic concepts involved in setting up and administering an ESOP are not really difficult. With a basic understanding of how ESOPs work, you will have an important strategic and economic tool at your command.

What, then, is an ESOP? An ESOP is simply a tax-qualified employee benefit plan that is designed to invest primarily in stock of the sponsoring employer. Probably the easiest way to understand how an ESOP works is to think of it as a variation on the traditional profit-sharing plan, contributions that your company makes to an ESOP are deductible (within limits), and income earned by an ESOP is exempt from tax. Further, participants in an ESOP do not recognize any taxable income as a result of employer contributions or earnings on their accounts until their benefits are withdrawn from the plan. The critical factor that distinguishes an ESOP from other types of employee benefit plans is that the funds of an ESOP are invested primarily in the stock of the sponsoring employer, while other employee benefit plans invest in stocks and bonds of other companies.

B. SPECIAL TAX INCENTIVES FOR ESOPs

Congress has created a host of major tax incentives designed to encourage employers to create ESOPs. While tax reform legislation has slashed the benefits available from so-called “tax shelter” investments, and has nearly eliminated other import tax planning techniques, the tax benefits associated with ESOPs have grown. As a result, ESOPs are the “big winner” under tax reform.

The most important of the special tax incentives created by Congress to encourage ESOP’s may be summarized as follows:

An individual can sell stock of a closely-held corporation to an ESOP on a tax-deferred basis if (a) the ESOP owns at least 30 percent of the stock of the sponsoring company immediately after the sale, and (b) the sale proceeds are reinvested in securities of other domestic corporations.

If a corporation uses an ESOP to obtain a loan, it can take tax deductions for both the interest and the principal payments on the loan, instead of being limited to deducting the interest only, as in the case of a conventional corporate loan. (For most companies, this can cut borrowing costs by one-third.)

Dividends paid on cash shares held by an ESOP are deductible by the sponsoring corporation (a) if they are passed through to the participants in the plan or (b) if they are used to pay off a loan taken out to finance the purchase of company stock.

C. PURPOSES AN ESOP CAN SERVE

As a result of these tax incentives, ESOPs now are attractive not only as employee benefits plans, but also as a techniques of corporate finance and as business and estate-planning tool. Because of these new tax incentives, ESOPs are being adopted by more and more companies, both large and small. The number of ESOPs has increased from approximately 1,600 in 1975 to over 10,000 in 1997, and the number of employees covered by these plans has mushroomed from approximately 250,000 in 1975 to an estimated 11 million in 1997.

The many tax incentives enacted by Congress to encourage the establishment of ESOPs make them attractive vehicles for a variety of purposes. In its simplest form, an ESOP is a tax-qualified employee benefit plan that provides a special kind of benefit to employees – an ownership interest in their company. A common objective of an ESOP is to increase employee productivity, which should result because, when there is an ESOP, the employees benefit directly from increases in the profitability of their company.

ESOPs also can be used for the following purposes:

to serve as a tax-advantaged technique of corporate finance;

to facilitate transitions in ownership and management of closely-held corporations;

to enable business owners to diversify their investment portfolios on a tax-free basis; and

to provide markets for a thinly-traded stock (and serve as an alternative to going public).