Updated February 8, 2021
Unlike the typical 401(k) plan, ESOPs aren’t an “off-the-shelf” retirement plan.
Until recently, each ESOP plan had to be individually designed to serve a specific set of purposes. The IRS recently allowed ESOP plan documents to be more like a 401(k) plan – with pre-approved options to choose from to create the overall plan design. But, regardless of whether the plan document is individually designed or “pre-approved” by the IRS, sellers still need ESOP specialists like us for guidance on creating an ESOP to advance their company’s business plan and employee benefits structure as well as the seller’s estate planning and personal goals.
This article explains our ESOP process. It describes how we guide clients from the decision of whether an ESOP (or another stock-based program) is right for the company all the way through to closing the ESOP transaction and beyond. We can’t detail all of the legal, tax, corporate and ERISA issues in one article, but we will identify the issues you’ll need to address.
Address Suitability First
We begin our relationship by giving you reading material to help you gain a basic understanding of ESOPs. You will learn first that ESOPs are a form of broad-based retirement plan intended to benefit most, if not all, of a company’s employees, and second, that ESOPs are complex, bringing with them significant tax incentives and planning flexibility, but often with a corresponding cost to achieve those benefits.
You then share with us a modest amount of data on the company, the principals involved, and their desired objectives. We do this through our “Suitability Questionnaire,” which you fill out and send to us with supporting documents. The questionnaire asks about existing retirement plans, corporate cash flow, corporate tax history, the parties involved, and the objectives that they hope to achieve with an ESOP. This “Suitability Review” is where we reconcile the hard data with the subtler issues so that we can come back to you with more probing questions.
We then sit down with you in a session that may take several hours. During that meeting, we examine issues we spotted in the Suitability Review. We also address your concerns, explore nuances of the business plan, and assess willingness to reconcile an ESOP’s benefits and trade-offs. At the end of our Suitability Review, you know what ESOP strategy would be a good fit for the company, or if another equity sharing program would better serve your needs. For example, various ESOP strategies may include some combination of bank financing and/or seller financing. Or we may recommend a non-leveraged ESOP alone or coupled with a 401(k) plan or money purchase pension plan. Or if an ESOP isn’t a good fit for the company, we may recommend another equity sharing program such as a restricted stock plan.
In most situations, we finish the Suitability Review process by giving you a planning report that:
- Describes the proposed ESOP transaction strategies.
- Identifies objectives and trade-offs for each proposed strategy.
- Identifies transition issues with the company’s existing retirement plan.
- Summarizes the specific alternatives to be evaluated in the feasibility study and transaction design phase described below.
Identify the Interested Parties and Fiduciaries
If the Suitability Review supports your desire to move forward, our next step is to educate everyone involved that they are about to create a new entity – a trust governed by federal law – which must be represented from the beginning of its existence by fiduciaries who act solely in the interest of the participants and beneficiaries of the trust.
How can we have fiduciaries this early in the process if we don’t know whether the company will ultimately adopt an ESOP? Technically, we can’t – no one is a fiduciary until the ESOP is formed. However, in the vast majority of ESOP companies, certain company “insiders” (for example, board members) serve as ESOP fiduciaries (trustees and Plan Administration committee members) with potentially conflicting obligations to the corporation, the ESOP, and the non-ESOP shareholders. In most cases, the potential conflicts do not become a legal problem, but we help ensure that by educating the potential fiduciaries of their duties and identifying the “interested parties” who cannot serve as fiduciaries. We help the board carefully select the fiduciaries of “the ESOP-to-be-formed” with a view to avoid conflicts and act prudently on behalf of the ESOP trust from the very first step in the process. The importance of this step is evident when we take the next step – obtaining a preliminary valuation of the company.
Obtain a Preliminary Range of Values
The fiduciaries of the ESOP-to-be-formed are responsible for obtaining a valuation of the company stock the ESOP may buy. Choosing the right fiduciaries makes a key difference here. The Internal Revenue Service, the Department of Labor, or the ESOP participants may later question whether the trustees acted solely on behalf of the trust in determining the value of the company stock or if they had some other motive in mind like enhancing the seller’s payout. At this stage, the company and any potential selling shareholders must understand that even a preliminary range of values is for the ESOP’s benefit only and for no one else’s primary benefit. This continues to be critical because an ESOP trustee must obtain a qualified independent valuation annually and as of the date of every ESOP stock purchase and sale transaction.
To move forward, therefore, the fiduciaries must obtain at least a preliminary range of stock values for ESOP planning purposes. Two important points to bear in mind at this juncture are:
- Do not confuse corporate perspectives or shareholder perspectives with the ESOP’s perspective of the company’s value. They may not be the same.
- This is a preliminary range of values. For initial planning purposes, a minority non-marketable assumption is a prudent starting point, and does not address in detail marketability discounts, control premiums or minority discounts. Those issues will be more fully taken into consideration if the actual transaction warrants an adjustment to value.
The ESOP fiduciaries should interview and engage a qualified, ESOP-experienced, independent appraisal firm to obtain the necessary valuation. More than one valuation firm should be interviewed. Sometimes clients have appraisals from their CPA or a valuation firm for estate planning purposes or for a buy-sell agreement. Those valuations may be useful for discussion purposes in the Suitability Review, but must be left behind if an ESOP is implemented. The valuation firm engaged by the ESOP fiduciaries must be the sole source of value opinions for an ESOP transaction.
Feasibility Study and Transaction Design
While the preliminary valuation is underway, the company can turn to the feasibility study and transaction design phase. This is where we guide you and your advisors through the tax and business planning issues. More than one advisor may be working simultaneously to accomplish the steps involved. A summary of the steps in the right order is as follows:
- A census of the proposed ESOP participants must be constructed to accurately assess tax deduction limits for the company and Internal Revenue Code (“Code”) limits on benefits to be allocated to participants. We may use existing retirement plan data and adjust it for differences in the ESOP plan design. For example, the company may want eligibility to participate in the employer-funded ESOP to be more restricted than in an employee-funded 401(k) plan. Limited eligibility could reduce the Company’s available tax deduction for contributions to the ESOP.
- If the ESOP is borrowing money to buy stock, either from a bank or from the seller, cash flow and transaction payoff calculations must be made. This is handled by the company’s chief financial officer and perhaps their CPA. The objective is to identify the discretionary cash flow available for ESOP benefits after all other corporate needs are met within the business plan.
- You may need to analyze the company’s status as an S corporation versus a C corporation. Sellers cannot use Code section 1042 to defer gain on the sale of their stock to an S corporation like they can with a sale to a C corporation. But S corporations offer greater cash flow efficiencies than C corporations when corporate and ESOP objectives are evaluated together. There may be tensions between selling shareholder objectives and corporate/ESOP objectives in evaluating these alternatives. The parties may decide to proceed with a C corporation transaction now and make an S election later. Conversely, if the corporation already is an S corporation, the parties may consider terminating the S election to make the Code section 1042 deferral available to the seller.
- Financial statement ratios need to be examined. The company’s CPA needs to identify the pre-debt and post-debt financial statement ratios and assess the impact of the proposed ESOP debt. All ESOP debt impacts the company’s financial statements. The needs of the client’s creditors, customers, and suppliers must be evaluated. The financial statement covenants in company lines of credit or other term credit facilities must be evaluated, including the ESOP debt impact. These ratios may be subject to negotiation with lenders as part of the transaction.
- Legal issues should be identified and prioritized. It may be necessary to budget for ruling requests to the IRS or tax or legal opinion letters to accompany the transaction. Other areas of law must be considered as well. Does the transaction raise securities law concerns? Are there corporate law issues to be resolved? Are there conflicts of interest?
This phase involves a lot of thought and “what if” questions. But it’s necessary and we’ll be there to help you ask the right questions or communicate directly with your other trusted advisors – whichever makes sense for you. When we’ve settled on a transaction structure, we’ll take care of drafting the transaction documents and circulating them to the seller, the board, the ESOP fiduciaries, the lender, and their respective attorneys for negotiation.
Plan Design and Installation
Once you’ve decided on a transaction structure, thoroughly evaluated the financial considerations, and cleared the legal hurdles, we can design and install the ESOP. Based on the census data and any existing retirement plans, we work with the company and the Third Party Administrator (TPA) to develop an ESOP plan design that takes the transaction structure into account and coordinates with the existing retirement plans.
Once the company approves the ESOP plan design, we prepare the plan document, a summary plan description, board resolutions adopting the plan, and other supporting documents. The named fiduciaries should read the plan documents carefully to be sure they understand how their fiduciary duties in the plan documents compare with the company’s responsibilities and authority as the plan sponsor. The board of directors then adopts the plan and formally appoints the fiduciaries.
The plan is submitted to the IRS for approval after it is adopted and before the tax return due date of the year for which it is initially adopted. The ESOP can be adopted any time up until the last day of the plan year for which it is initially effective.
Transaction Steps – Doing the Deal
It is possible for the transaction steps to take place simultaneously with the plan design and installation. In this phase, the company and the ESOP fiduciaries secure necessary financing and negotiate the purchase of shares.
While clients often prefer to stay with their existing lenders if financing is involved, finding a lender with ESOP financing experience will save time and money, both in the short- and long-term. It is rare for an ESOP lender to participate in financing a company without having an all-encompassing relationship with the client, except in cases of the largest ESOP companies and clients.
The ESOP fiduciaries and the company’s board of directors have an obligation to obtain the best available financing at the lowest possible cost. The ESOP fiduciaries have an obligation to accrue only a prudent level of debt. Over-leveraging the ESOP and the company is imprudent. How do you know what is prudent? Financing should be coordinated with the steps in the feasibility study described above where available discretionary cash flow is determined and the financial ratios are assessed. To a certain extent, the fiduciaries can rely on this “sensitivity analysis,” but that does not relieve the trustees from making their own independent evaluation of whether or not the debt being offered to the ESOP is prudent. The ESOP fiduciaries may engage a feasibility modeling company or the ESOP’s appraiser acting as an independent financial consultant to the ESOP to assess the impact of the debt.
The bank produces loan documents to be reviewed by the company’s counsel and ESOP counsel. The loan documents and the terms of the financing are almost always between the bank and the company with the company providing funding to the ESOP for the purchase through a “mirror” loan. All of the funding must conform with the ESOP regulations to avoid the loan being treated as a “prohibited transaction.” The company’s CPA also reviews the bank loan documents to determine that the company can comfortably meet the covenants and ratios. If all goes well, in a matter of weeks to months, loan documents and transaction documents are finalized and the stock is transferred to the ESOP in exchange for the financing.
What to Do?
Investigating and implementing an ESOP can seem like a daunting task that requires a lot of hands-on investigative work by the client and a good team of advisors. However, we’ve developed our proven ESOP Process to take you through the right steps in the right order. Over the decades, we’ve found that this process yields a higher level of certainty that the ESOP is compatible with the company culture and that it promotes the company’s business objectives and the objectives of the company’s other shareholders. Call or email us to get started with a Suitability Review.
