Strategies For Aging ESOPs

This topic was derived from an article on the subject in the March, 2000 issue of the Journal of Accountancy, published by the American Institute of Certified Public Accountants (AICPA).  The following discussion includes a few references to this article and additional comments and observations from FTSI’s experience over a number of years in ESOP consulting.  Any references to tax treatment relate to federal tax rules only.  Readers should consult with their tax advisors regarding individual state tax laws.

In view of the complexities of the financial accounting and federal tax rules governing ESOPs, many ESOP sponsoring companies lose sight of larger issues and become mired down in the technical details.  To be sure, the accounting and tax pros and cons must be addressed in any realistic analysis of alternative strategies.  Short term tax and accounting benefits or disadvantages should not overshadow longer term perspectives, however.

A very typical scenario in the life cycle of ESOPs is the case where the plan was originally adopted to provide a tax-favored means of buying out the equity of one or more major shareholders in a privately held corporation.  This objective can be accomplished using borrowed funds from a bank lender or funds provided by the corporation in the form of a loan to the ESOP trust.  Whatever the method, over time the buyout is completed, successor management is firmly in place, and the equity that was formerly owned by the selling shareholders becomes equity owned beneficially by the plan’s employee participants.  Up to this point, the corporation has enjoyed the advantage of deducting the yearly contributions made to the plan to service the loan to accomplish a well defined purpose.  For the publicly traded company, there is little downside in such a case since the shares that are distributed to retiring and terminating employees can be sold on the open market.  The corporation, in this case, is burdened only with the administrative costs of operation of the plan.

There Is No Free Lunch

For the privately held corporation, however, accomplishment of the original objective triggers the check for what may have been perceived earlier as a free lunch.   Federal tax rules require that employee participants must be granted a “put option” wherein the company is obligated to buy back the shares from separated participants at the then current fair market value.  Without this provision, the prospect of owning shares in a private corporation with little or no market would be of nominal interest to most employees under most circumstances. This obligation to fund the conversion of ESOP shares into cash is referred to as the “repurchase liability.” 

The article mentioned in the introduction cites as a potential problem the need to meet employee expectation of continued share allocations to their ESOP account after the loan is repaid.  Continued federal tax deductible cash contributions can be made to the ESOP and invested in other securities or used to buy additional employer company shares, either newly issued or from non ESOP shareholders.   Launching into a new round of borrowing is not necessary.  Alternatively, the company can merely contribute newly issued shares for which a federal tax deduction is available.   Remaining plan participants receive additional shares in their accounts from the forfeiture of unvested shares of separated employees.  If the share values increase over time, this is another means of realizing appreciation in the individual ESOP accounts.  Increasing share values, however, mean increasing repurchase liability.

Importance Of A Strategy

Another alternative, and one that is frequently rejected, is to adopt a policy of purchasing shares from separated participants by the company as opposed to contributing cash to the trust to fund the trust’s “repurchase” of such shares.  This is, of course, an outlay of cash for which no federal tax deduction is available. When the trust uses deductible cash contributions to buy back shares from separated participants, these repurchased shares are reallocated to the remaining participants and the process continues ad infinitum as the same shares are purchased over and over again by the trust.  Buy back of shares by the company, however, leads to a reduction or possible total elimination of this liability.  If this alternative appears to be the most feasible, other forms of incentive compensation or retirement oriented benefit programs should be considered as part of the transition.  In other word, an overall strategy should be implemented and not merely a myopic analysis focusing on the tax deductibility of continued cash contributions.

Unless the ESOP is used by successor management to achieve new objectives such as funding acquisitions with tax deductible dollars or other strategies that offset the negative aspects of the drain on corporate cash flow to fund ever growing repurchase liability, the long term advantages of winding down the ESOP’s share holdings should trump the short term advantage of the deductibility of yearly cash contributions to fund repurchases.  Recognition of the need to formulate changing strategies for changing circumstances should be made at the outset when the plan is initially adopted.  Unfortunately, many ESOP consultants who specialize in ESOP installations avoid mention of the need for such long term strategy considerations for fear the prospective ESOP client will be distracted from the prospect of the ostensible free lunch.

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