Here are just a few: Contributions of stock and cash, as well as dividends, are tax-deductible; contributions used to repay a loan the ESOP takes out to buy company shares are tax-deductible (regarding both principal and interest); sellers in a C corporation can get a tax deferral; and employees pay no tax on the contributions to the ESOP, only the distribution of their accounts, and then at potentially favorable rates.

Employee stock ownership plans (ESOPs) have become more popular because they provide numerous benefits.

Despite these and other pluses, the decision to install an ESOP shouldn’t be made lightly. Nine of 10 employers considering an ESOP walk away after completing a feasibility study, often because they realize ESOPs are complicated to set up and difficult to shut down. That’s why it’s essential to follow leading practices in these five crucial areas.

5 areas that can make or break an employee stock ownership planMark Ritter, Managing Director, Compensation and Benefits Consulting

An ESOP is a defined contribution, tax-qualified retirement plan designed to invest primarily in the stock of the sponsoring employer. The ESOP’s sponsoring company, the selling shareholder(s) and plan participants receive various tax benefits.

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5 areas that can make or break an employee stock ownership plan

Commission studies that lay the groundwork To help decide whether an ESOP is a workable option, employers should commission two studies: a feasibility study and a repurchase obligation study.

A feasibility study aims to generate enough information to allow affected parties to decide whether to proceed with an ESOP. The study should be conducted by an independent adviser or advisers such as an accounting firm or a specialized law firm, and it should include a stock price determined by an independent qualified appraiser.

An important and separate part of the feasibility review is a repurchase obligation study, which is a long-term projection of ESOP distributions and related cash requirements the company will face. In a closely held company, if an employee has shares in the ESOP and leaves the company, the ESOP usually stipulates that he or she can’t take the shares. Instead, the ESOP pays the employee in cash for the current market value of the shares. In addition, the ESOP’s cash needs may include debt service on a securities acquisition loan (leveraged ESOPs). However, the ESOP’s only cash for these distribution transactions and debt service are dividends, which often aren’t a material amount, and the employer’s profit-sharing contribution in cash that year. The ESOP uses the cash to buy shares from departing employees and reallocates the repurchased shares among the employees still in the plan.

The purpose of the repurchase obligation study is to project these cash needs by forecasting future balances accumulating in the plan, as well as turnover and retirements, stock price growth over time and related factors. The independent adviser matches forecasted cash needs against the company’s projected cash flow and ability to make required contributions on a deductible basis. Make sure the study includes robust financial projections for the company’s long-term cash flow because these projections may vary considerably over time.

Use an installation checklist “Installation” refers to implementing the plan, and most of the steps are dictated by the Employee Retirement Income Security Act (ERISA) and the Internal Revenue Code. It’s critical to use a checklist that includes entries for appraisal of the stock value. To comply with rules governing the price the plan will pay for the stock, an employer must commission a proper appraisal before implementing the ESOP (unless the stock is regularly traded on an exchange). A poorly executed appraisal can be costly. The Department of Labor (DOL) has filed 28 lawsuits involving ESOPs since October 2009 — double the number filed in the six years prior — and it has recovered more than $262 million through lawsuits or investigations resolved without going to court, according to The Wall Street Journal. Most involved flawed valuations, WSJ reported.

There’s also a potentially more-direct cost. Suppose an appraiser values the stock at $100 per share, and the owner receives $1 million when selling it. Later, an employee benefit auditor asks another appraiser to review the valuation, and this appraiser finds a significant math error was made and the true value of the stock is only $50 per share. The law would require the seller to return $500,000 of that cash to the ESOP trustee.

It’s critical to use a checklist that includes entries for appraisal of the stock value. To comply with rules governing the price the plan will pay for the stock, an employer must commission a proper appraisal before implementing the ESOP (unless the stock is regularly traded on an exchange).

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5 areas that can make or break an employee stock ownership plan

ESOP implementation checklistA checklist like the following can help you track your progress through the key steps in planning and implementing an employee stock ownership plan (ESOP).

Clearly define your goals in implementing an ESOP. As the feasibility process progresses, emerging facts may show a good or bad fit for various goals. It’s important to be clear about what you’re trying to accomplish before you get mired in regulatory and other details. Use the following list as a starting point for goals.

Create an exit strategy for the current owner

Align employees’ interests with those of other shareholders

Provide for employees’ retirement

Other (list)

Obtain an objective, third-party estimate of the value of the stock. Current owners of the business often think they know what the value of the company’s stock should be and are surprised when third-party professionals come up with a different value.

If creating a market for the company’s stock is an important goal, find out what kind of value can be ascribed to the company’s stock under the labor law rules regarding ESOP stock valuations. If the price equals or exceeds the owner’s expectations, all is well, but if it’s lower than expected, it may be important to consider early on whether a qualified retirement plan is the best way to create a market for the stock.

Conduct a thorough feasibility review.

Perform a funding obligation study. ESOPs need cash to repay stock acquisition loans and to cash out participants whose balances may grow considerably over time. The only source of funding for an ESOP is company contributions and any dividends on the stock held by the ESOP, and this may have a material impact on the company’s cash flow over the years.

Consider how an ESOP fits with other employee benefit programs such as the company’s 401(k) plan.

Factor in timing (i.e., should the ESOP take out a loan and buy all of the company’s stock immediately, or should it buy incremental amounts each year?).

Evaluate whether the ESOP will need financing via a securities acquisition loan. Should the lender be the company, the selling shareholders or a bank?

If you’re the current owner, think about whether you want to relinquish control of the company or instead sell less than 50% of the company’s stock to an ESOP.

Determine the tax benefits available to selling owners. Owners of a C corporation may be able to defer gain recognition on the sale of their shares, but owners of S corporations don’t have that benefit.

Evaluate how the current owners feel about employee co-ownership. Even when the ESOP doesn’t control a company outright, voting rights must be passed through to plan participants in certain circumstances.

Consider what key constituencies, such as management and rank-and-file employees, think about the idea. Will they be excited to co-own the business, or might they prefer greater investment diversification than an ESOP provides?

Line up the right service providers. These will include a law firm; a third-party appraisal company; an accounting firm; an ESOP trustee; a lender, if the ESOP will be leveraged; and possibly a qualified professional asset manager (or similar independent financial adviser) to prepare a fairness opinion. Each provider plays a specific role in conducting an ESOP transaction, and it’s important to select providers who are experienced with ESOPs so that they can better manage risk from a technical standpoint and avoid fiduciary mistakes.

Evaluate whether the providers under consideration will work well as a team.

Define roles early on to avoid missteps and duplicated efforts.

Establish a timeline and execute the plan. If everything has gone well in the preceding steps, the company can work with the various service providers to do the following:

Develop a timetable

Write plan documents

Arrange funding and the stock sale itself

Communicate the plan to the company’s employees

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5 areas that can make or break an employee stock ownership plan

Choose a corporate trusteeCorporate trustees tend to be better regulated and therefore have better internal controls than individuals like company employees. Because corporate trustees must obtain trust powers under a federal or state charter, they are regulated and regularly examined by agencies like the Office of the Comptroller of the Currency. It’s smart to choose a regulated financial institution, partly because you’ll be piggybacking on all the regulation and review these companies undergo. Also, because of this regulatory environment, these institutions have already invested in processes and procedures to mitigate the risk of mistakes.

In addition, corporate trustees have better insurance and can prove their independence relatively easily unless they have common ownership with the company sponsoring the ESOP, which is rare. Because a corporate trustee is in the business of being a trustee and knows how to manage risk, such an institution is less likely to make an inadvertent error based on ignorance of fiduciary responsibility rules.

Communicate in person with employeesCommunication about how the plan works and benefits employees is especially important with an ESOP. Employees don’t get money from the plan until they’re on their way out the door, and all they really know about the plan is what they’re told. Employees who don’t understand their retirement plan are more likely to sue their employer when the plan doesn’t meet their expectations.

Here’s how the communication may go. The employer tells an employee, “By the way, Joe, we’ve got an ESOP now, so you’ll get some money when you leave.” And Joe asks, “Why did you do that?” And the employer says, “I’m selling all my shares in the business. I want to get out of being the owner. Your shares will be worth some money. We’ll see if we can get you a statement once a year.” Joe is worried because a large part of the company was just sold. He thinks, “You’ve done something for your best interest, and if I come out ahead, that’s going to be an accident, not an intended result.”

So the way the employer communicated shaped Joe’s perception. If employers don’t tell employees much about the plan, employees won’t think much of it. Also, employers need to prepare employees for the possibility of declining value of the stock in the plan.

Here’s a more effective approach. You, the employer, say, “Great news. We’ve been looking at various financing techniques for the company, and one of them involves creating a benefit for you as one of the owners of the company. Joe, you’ll become one of the owners.” Joe asks, “Does that mean you’ll give me shares?” You say, “No, the law governing qualified plans won’t let us do that or you’d be taxed immediately, but it will be held in a trust for you with an independent trustee.”

Joe asks, “How much do I get?” You explain the allocation formula, the way the plan works, the number of shares Joe will get based on his salary and when he qualifies to take a distribution (usually when he is separated from service). You add that you have to make contributions every year because there’s a debt service to pay and that Joe will get shares every year, so it’s not discretionary. You remind Joe that unlike a 401(k) plan — where he might pay 80% of the cost of the plan — the ESOP generates proceeds that are all “free money,” 100% funded by the company.

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5 areas that can make or break an employee stock ownership plan

Exercise and document fiduciary duty ESOPs have more fiduciary exposure than most other kinds of plans because the DOL and some employees may become suspicious about the price the trust paid the owners for the stock. With heightened fiduciary risk comes a greater need to perform fiduciary processes correctly.

Employers, trustees and other plan fiduciaries should make sure that when they make decisions about the plan, they’ve thoroughly documented their due diligence in getting information about the decision and have used great care in making all decisions that exclusively benefit the plan participants. It can’t be stressed enough that fiduciaries should keep a complete record of the decision-making process.

A primary area to document is the share price valuation. Hire an outside appraiser who is independent of you, get the appraisal, read it, make sure the information and assumptions they use make sense for your company, talk to the people who worked on it and ask if more than one price is possible. (The answer should be yes.)

Document all of the other actions you take — meeting with the fiduciary committee, talking to a law firm, hiring outside experts as advisers and so on. If the DOL shows up with questions, you can produce a file that proves you performed due diligence and documented it, and that the valuation represented a fair price.

If managed properly, ESOPs can provide tax benefits to business owners and serve as a profit-sharing plan for employees. The key is to follow leading practices in getting the studies done; installing the ESOP properly, including getting a sound appraisal of the share value; selecting a corporate trustee with ESOP experience; communicating effectively with employees; and documenting thoroughly how all fiduciaries perform their duties.

ContactMark RitterManaging DirectorCompensation and Benefits Consulting+1 404 704 0114mark.ritter@us.gt.com

Content in this publication is not intended to answer specific questions or suggest suitability of action in a particular case. For additional information about the issues discussed, consult a Grant Thornton LLP client service partner or another qualified professional.

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