Employee stock ownership plans, or
ESOPs, are the most common form of
employee ownership in the United States. 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,” points out 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 their 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 result 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 semina 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].