Employee stock ownership plans, or
ESOPs, are the most common form of
employee ownership in the country.
Originating more than 80 years ago, ESOPs
were first recognized by the government in
1974. Now thousands of companies have
these plans covering millions of employees.
Among other things, ESOPs can be used
to provide shareholder liquidity, to motivate
and reward employees, and as an attractive
form of debt financing. “There are many
ways a company can benefit from an ESOP,”
says Michael Savoy, managing director of
Gumbiner Savett Inc.
Smart Business spoke with Savoy about
ESOPs, how they have evolved and the benefits they provide.
How have ESOPs evolved over the years?
Employee stock ownership plans have
been around since 1916 when Sears
Roebuck decided to fund its pension plan
primarily with company stock. The basic
concept was that the employees’ ownership
of Sears stock was not only a good retirement benefit, but was also an excellent way
to motivate employees to improve the company’s profitability and, thus, the value of
what they owned. In the early 1970s, the concept caught the eye of Senator Russell Long
of Louisiana, who was the chairman of the
Senate Finance Committee, and the whole
idea gained momentum within the government. In 1974, with the help of Senator Long,
the concept of employee ownership was formally recognized by the federal government.
Since then, a series of tax laws has been
enhanced and modified to provide tax incentives that encourage employee ownership.
How can a company benefit from the establishment of an ESOP?
Firstly, a business owner can, under certain circumstances, sell his or her shares to
an ESOP and either defer or, in some cases,
completely avoid paying taxes. Companies
can also make tax-deductible contributions
to ESOPs, which results in a tax shield that
creates value. Employees who purchase all
or part of a company through an ESOP have
a unique opportunity to build wealth via the
underlying stock appreciation without assuming any personal liability. Finally, one of
the most important benefits that companies
can realize from the establishment of an
ESOP is what I call the productivity benefit.
Published studies have shown that companies report significant productivity improvements after establishing an ESOP.
In what ways can ESOPs spur employee
motivation?
If employees own a piece of the business,
they do things differently than if they are
just employees. At an ESOP seminar I
attended, a CEO related a story about a
receptionist that now owns a piece of her
company. The receptionist was put in
charge of purchasing office supplies. All of a
sudden, she started taking bids and shopping around for the best prices. This resulted in the company saving tens of thousands
of dollars. This is just one aspect of productivity improvement, and it illustrates how
people at all levels take pride in ownership.
How do ESOPs create a shareholder liquidity
alternative?
Most business owners today have the
majority of their personal net worth tied up in their business. Through the use of an ESOP,
they are able to sell some, or all, of their company to employees. They can still maintain
control of their company and, thus, diversify
their assets while in most cases paying
absolutely no taxes on the transaction.
What is the difference between a nonlever-aged ESOP and a leveraged ESOP?
The difference is that no borrowing takes
place with a nonleveraged ESOP while borrowing takes place with a leveraged ESOP.
A nonleveraged ESOP is similar to other
tax-qualified pension or profit-sharing
plans. A company can make annual tax-deductible contributions, generally limited
to 15 percent of employee salary, to an
ESOP in the form of cash or stock in the
company. If you donate additional shares of
stock to an ESOP, not only is the company
getting a tax deduction for the value of
those shares, but there is no cash coming
out of the company.
In a leveraged ESOP, the company borrows money, either through the shareholder or a third party, such as a bank, to repur-chase shares from the existing shareholder.
In the case of a leveraged ESOP, the limit
for annual tax-deductible contributions is
25 percent of employee salary. An additional benefit is that payments of both principle
and interest are tax deductible.
How do ESOPs create value?
Aside from the potential productivity
improvements, there are also many economic benefits. As we discussed earlier,
with nonleveraged ESOPs, if you donate
shares of stock, your company is making
no cash contributions and, thus, tax savings are realized simply through the
issuance of additional shares of stock.
For instance, if a $1 million dollar contribution were made in the form of stock,
a company with the 40 percent corporate
tax rate would be saving $400,000 in
taxes and there would be a $400,000 cash
flow improvement. There is no other
type of vehicle that allows this type of
transaction.
MICHAEL SAVOY is managing director of Gumbiner Savett Inc. Reach him at (310) 828-9798 or [email protected].