| Fall 2008 |
Manufacturing/Distribution Advisor
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ESOPs Maximize Owners' Value
In planning for their own long-term financial security, business
owners should consider the advantages of an employee stock ownership
plan, or ESOP.
By establishing such a plan, owners can receive the maximum value of their
holdings on a tax-free basis, bequeath tax-sheltered funds to heirs and still
maintain control of the company.
An ESOP is a retirement plan whose assets, i.e. shares in the company, are
owned by the ESOP trustee for the benefit of the employees. When it's
established, it borrows money to buy some or all of an owner's shares. The ESOP
loan is guaranteed by the company, and the company services it with
tax-deductible contributions.
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Deal Breakers
Certain circumstances usually rule out the ESOP option. Two of the more
common deal breakers are:
Low appraisal - The law requires an appraisal by an independent
professional business valuation firm to determine the "fair market value
of the company's stock." The ESOP cannot pay more than fair market value.
Large debt - Companies that are heavily leveraged aren't good
candidates for ESOPs. |
When ESOPs Took Off
ESOPs have existed for years but became widely popular in the late 1980s,
when many small and mid-sized businesses were being acquired by larger companies
via tax-free stock swaps. The conglomerates moved or eliminated jobs in some
locales and communities protested. Congress passed IRC Section 1042, which
extended the tax benefits of a stock swap to ESOP plans.
By selling a business to an ESOP instead of a distant corporation, an owner
can receive the same value and protect local jobs.
Tailor-Made for Manufacturers
Most ESOPs are leveraged, using borrowed money to buy stock from the selling
shareholders. Thus, ESOPs are particularly attractive to companies with strong
borrowing capacity - like manufacturers, whose physical assets stand them in
good stead with lenders. Most distributors can also borrow an adequate amount.
Many owners of manufacturing and distribution companies have 80 or even 90
percent of their worth tied up in their business. An ESOP makes this wealth
liquid and available for a more balanced investment portfolio.
Cash Value, Tax Protection, Control
An ESOP carries different tax advantages depending on the corporate form. In
a C corporation, the seller avoids all capital gains taxes, a strong incentive
to owners with little or no basis in company stock who would owe substantial tax
on other kinds of sales. In order to receive this favorable tax treatment, the
ESOP proceeds must be reinvested in compliance with IRC Section 1042.
To the extent an S corporation is owned by an ESOP, that proportion of the
company's income is tax free. So a 100-percent, ESOP-owned S corporation and its
shareholders pay no income tax.
Owners can maintain control in two ways. One, of course, is to sell less than
half the stock. The other is to sell the majority of stock, but appoint a
"directed" trustee of the ESOP. The directed trustee will vote its shares based
upon direction from the ESOP committee, which is appointed by the board of
directors. Control lies with the ESOP committee appointed by the company's board
of directors, which is elected by holders of voting stock.
Employee Education
At a company's first meeting to explain a new ESOP and its benefits, don't
expect a standing ovation. Employees won't automatically understand or believe
what the ESOP promises.
Some may focus on changes to their existing retirement plans, which normally
remain in place. But since the company needs cash to service its ESOP debt, it
will usually end its match of employee 401(k) contributions.
But if a company delivers the same explanations consistently, and employees
see contributions coming in and their own accounts growing, fewer eyes will
roll. When the first retiree receives a check, most employees become believers.
There are also creative ways to replicate the 401(k) match. For every dollar
an employee puts in a 401(k), for example, the company could put a dollar of
stock into the employee's ESOP account. Such measures often result in increased
employee contributions.
ESOPs offer great benefits, but they're anything but simple. Our firm can
help put together a team to properly assess this option with you.
Manufacturing / Distribution Advisor is produced quarterly by Bober, Markey, Fedorovich & Company’s Manufacturing / Distribution Services Team. If you would like additional information about the services that we provide to manufacturers and wholesale distributors, please call or email our team leaders James E. Merklin, CPA, CFE, M.Acc. or Cindy S. Johnson, CPA, CIT at (330) 762-9785 or
jimm@bobermarkey.com or
cindyj@bobermarkey.com.
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