Frequently Asked Questions

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Q:What is an ESOP?
A:Simply put, an ESOP is a both a corporate finance tool and an employee retirement plan at the same time. Congress allows special tax benefits to business owners who are willing to sell their stock to a qualified trust of which the employees are the beneficiaries. The employees benefit from the value of the stock when it is sold to fund their retirement at the appropriate time.
Technically, ESOPs are tax-qualified, defined contribution plans that are stock bonus plans or a combination of a stock bonus plan and money purchase plan designed to invest primarily in employer securities.
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Q:What is TPA?
A:A Third Party Administrator (TPA) is an organization that specializes in keeping records for, filing forms for, and processing transactions for employment benefit plans for a separate entity. This can be thought of as "outsourcing" the administration of benefits plans, such as Employee Stock Ownership Plans (ESOPs), to a firm whose sole purpose is to manage this process efficiently.
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Q:Why do I need a TPA?
A:Many employee benefit plans have highly technical aspects and complex administration requirements that can make using a specialized entity, such as a TPA, more cost effective than trying to do the same processing in house. An ESOP, for example, must remain in strict compliance with ERISA, Department of Labor, IRS and Securities and Exchange Commission laws. Failure to remain compliant can result in the ESOP being disqualified. Such disqualifications create very real problems with employees, with corporate accounting, banking relationships as well as with the IRS.
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Q:How does the leveraged ESOP transaction work?
A:Leveraged ESOPs are distinct from other types of employee benefit plans. A leveraged ESOP borrows money from the company, the selling shareholder(s) or third-party lender (hence “leveraged”) using a guarantee or other extension of credit and purchases, either: (1) existing stock or (2) newly issued stock. Leveraged ESOPs are economically attractive for the following reasons:
  • Contributions by the company to pay both interest and principal payments on ESOP debt are tax-deductible within certain limits. Thus, annual tax-deductible ESOP contributions are used to repay the principal on the outstanding ESOP indebtedness to the lender.
  • Cash dividends on ESOP stock used to repay ESOP debt may be tax-deductible. Consequently, leveraged ESOPs can actually create value by virtue of the tax shield created. The leveraged ESOP can purchase existing stock or newly issued stock, which is a unique corporate finance tool.
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Q:Why can’t I just handle my own plan administration?
A:You can. But, consider this. Every year there are approximately 500 new laws, regulations, interpretations, opinions, announcements and major court cases impacting employee benefit plans or sponsoring employers. Not all of them will apply to your plan, but you need to know which ones do.
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Q:Is an ESOP compatible with my 401(k)?
A:A 401(k) plan is fully compatible with an ESOP since 401(k) plans and ESOPs are both defined contribution plans. Most ESOP-owned companies also have 401(k) plans though not out of necessity. If the company has a separate 401(k) plan, the plan may be continued as a separate plan. However, the company may want to consider having future matching contributions go to the ESOP rather than the 401(k) plan.
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Q:How does an ESOP create a shareholder liquidity alternative?
A:The ESOP creates a “friendly” buyer for the stock. Furthermore, an ESOP is designed to enable a business owner to achieve his objectives:
  • The seller may sell stock to an ESOP and still be able to run the company. (The ESOP, however, must be operated under ERISA guidelines).
  • The seller may sell stock to an ESOP over time when it is convenient (rather than all at once as a traditional purchaser would require).
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Q:What is a Section 1042 Transaction?
A:If an ESOP purchases at least 30 percent of the outstanding stock of a privately held "C" corporation and the selling shareholder(s): (1) are individuals, partnerships, taxable trusts and estates, (2) have owned their stock for at least three years, and (3) are otherwise eligible for capital gains treatment, the selling shareholder(s) can defer virtually indefinitely the taxes on their gain. To obtain this tax benefit, the selling shareholder(s) must reinvest the proceeds in "qualified replacement property" within a period beginning three months prior to the sale and ending 12 months after the sale. Such a Section 1042 transaction, which derives its name from the section of the Internal Revenue Code (the "Code") which governs its availability, is often referred to as a "1042 Rollover" or "Tax Free Rollover".
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Q:What is Qualified Replacement Property?
A:In general, qualified replacement property (QRP) includes stocks and bonds of U.S. corporations, both public and private. QRP includes, for example, common stock, preferred stock, corporate notes and bonds, convertible bonds and floating rate notes. QRP does not include U.S. government municipal securities, foreign securities, mutual funds, limited partnerships or the stock of the corporation (or its affiliates) that is the subject of the ESOP transaction. In addition, brokerage and investment firms offer products that essentially allow the seller to borrow against his QRP to provide further personal liquidity.
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Q:How significant is a tax deferral to a selling shareholder?
A:Extremely significant. Sellers should always analyze any proposed transaction alternatives on an after-tax proceeds basis. Although selling a portion of a business to an ESOP may result in a lower selling price than selling to a strategic buyer, the indefinite deferral of capital gains taxes for the selling shareholder usually far outweighs any price difference.
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Q:If I sell a portion of my company to an ESOP today, will that make my company less attractive to investors or buyers at a later date?
A:No. Because the ESOP acts as a single, integrated entity, it should be viewed as simply another shareholder whose acts are controlled by a sophisticated investor (the trustee), which can be a trust department of a bank, a trust company or an individual.
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Q:Which shareholders can take advantage of a 1042 Rollover?
A:Individuals, trusts, partnerships and estates, as shareholders of a privately held “C” corporation, may elect the 1042 Rollover. Shareholders of an “S” corporation are not eligible for a 1042 Rollover.
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Q:What is a tax-qualified employee benefit plan?
A:A tax-qualified employee benefit plan is a retirement plan that meets special rules for tax qualification under Section 401(a) of the Code. Employer contributions to tax-qualified plans are tax-deductible within certain limits. A 401(k) is one example of such a plan as is an ESOP.
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Q:What is a defined contribution plan?
A:In the broad category of tax-qualified employee benefit plans; there are two general categories of plans: defined benefit plans and defined contribution plans. Defined benefit plans provide a fixed schedule of benefits for an employee upon retirement with varying, but mandatory, annual company contributions. ESOPs, by contrast, are defined contribution plans to which the company makes annual contributions, which may vary year to year. The income an employee receives from an ESOP upon retirement is a function of the contributions made to the plan and the performance of plan investments, rather than a pre-determined benefit based on a fixed formula.
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Q:How does an ESOP differ from other types of defined contribution plans?
A:In general, while defined contribution plans may invest all or a portion of their assets in employer stock, ERISA suggests that defined contribution plans (other than eligible individual account plans) invest in a diversified portfolio of securities. However, ESOPs are designed to invest primarily or exclusively in the stock of the sponsoring company and may borrow money to make these investments.
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Q:How much can be contributed to an ESOP?
A:In general, a company can contribute up to 25 percent of covered payroll to an ESOP. In certain cases, the company can contribute up to 25 percent to the ESOP just to repay principal on the ESOP’s debt; in addition, interest expense on the ESOP’s debt may also be tax-deductible. Section 415 of the Code provides that the contribution to each individual participant cannot exceed the lesser of $49,000 (for 2009) or 100% of the employee’s annual compensation.
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Q:How is stock allocated to an employee’s account?
A:In general, stock allocations for both non-leveraged and leveraged ESOPs are based on a formula using individual participant’s compensation.
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Q:Can ESOPs contain vesting provisions?
A:Yes. An ESOP must comply with one of two minimum vesting schedules under ERISA: (1) 100 percent vesting after five years of service or (2) 20 percent vesting per year beginning in year three and continuing through year seven. For plan years beginning on or after 1/1/07, the ESOP must comply with vesting provisions under the Pension Protection Act of 2006 (“PPA”) in that 100% vesting will occur after three years of service or 20% per year beginning in year two and continuing through year six. An exception to this is that leveraged ESOPs with a loan in place on September 26, 2005 may continue to use the five-year cliff or seven-year graded schedule until the plan year in which the ESOP loan is fully repaid.
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Q:Do employees vote their stock in the ESOP?
A:Employees have the right to vote only on certain major corporate issues such as the sale of the assets of the company, liquidation, etc.
On all other matters, and with respect to shares not yet allocated to participants, the ESOP trustee exercises voting rights, in accordance with fiduciary guidelines of ERISA.
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Q:While ESOPs are, by their very nature, essentially undiversified benefit plans, are there any diversification options or requirements?
A:Yes. Employees who have attained the age of 55 and have participated in the ESOP for at least ten years (three years for ESOPs of publicly traded corporations) may elect each year, over a subsequent six-year period, to diversify up to 25 percent of their ESOP shares. In the last year of this period, qualifying employees have an opportunity to diversify up to 50 percent of their shares, reduced by amounts previously diversified.
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Q:How do employees sell the stock they receive from the ESOP?
A:ESOPs in privately held companies provide a “put option” to the employees who receive stock (rather than cash) from the ESOP. In general, departing employees have the right to “put” their stock back to the company (or the ESOP) at fair market value. Payments are made in a lump sum or on an installment method.
Distributions from ESOPs in publicly traded companies are not subject to this “put option” requirement because employees can sell their stock in the open market.
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Q:Does the ESOP participant’s "put option" create a repurchase obligation for the company?
A:Yes. However, the perceived burden of the repurchase obligation should not be overstated. Proper corporate planning can easily address this obligation. Many strategies exist, including funding the repurchase obligation with cash contributions to the ESOP or cash accumulations at the company level, purchasing insurance or re-leveraging the company.
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Q:What is fair market value?
A:Fair market value is generally defined as the price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well informed about the asset and the market for such an asset.
Fair market value is always stated as of a specific point in time. Fair market value may change from day to day, as it does with publicly traded stocks.
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