While we primarily focus on consummating traditional leveraged buyouts, we can also structure our buyouts so that selling shareholders, management and employees realize the tax, financial and employee performance improvements provided by properly structured ESOP transactions. In many instances, such transactions can provide unique benefits not possible with traditional buyouts. We are one of the few investment groups in the country with deep expertise in ESOP transactions that focuses on smaller transactions.

Links to ESOP Information Sources

• NCEO
• The ESOP Association
• Article s demonstrating improved performance by ESOP companies


SUMMARY OF ESOP INCENTIVES

Individual Tax Benefits to Sellers
Owners of privately held companies are frequently eligible for "tax-free" rollover treatment when they sell their interests or stock to an ESOP. Individuals (or partnerships, trusts, etc.,) who own interests in a closely held business entity may be eligible for "tax free" rollover treatment of IRC Sec 1042, provided that the initial sale to the ESOP is for an ownership stake of 30% or greater, and the shareholders otherwise qualify. The other requirements include ownership of the business interest for at least three years, and reinvestment of the proceeds from the sale to the ESOP in stocks or bonds of U.S. operating companies within twelve months after the sale to the ESOP.

Sellers may not qualify to elect the "tax-free" rollover for a variety of reasons. While most technical issues related to qualification can be overcome, some common disqualifying fact patterns include: a) the sellers may have received their interests or stock through some form of stock option plan or other method that makes it ineligible, b) the interests or stock may be owned by a corporation, or c) the company may be publicly held. In these instances, the interests or stock sold to the ESOP would be subject to capital gains tax treatment, provided the normal one-year holding period had been satisfied.

Corporate Tax Benefits
A C-Corporation with an ESOP receives tax deductions for making contributions to the ESOP. In a leveraged ESOP, the ESOP receives a loan and uses the proceeds to purchase a block of stock from current shareholders. (The loan is frequently made to the corporation by a bank and/or investors, and then the company re-lends the money to the ESOP. The corporation which sponsors the ESOP must guarantee the ESOP debt.) The company or selling shareholder(s) can also provide some of the financing. The stock purchased by the ESOP is held in a Trust. As the C-Corporation makes tax deductible contributions to the ESOP to repay the debt, shares held in an ESOP suspense account are allocated to employee accounts at a rate corresponding to the debt amortization. Plan participants vest in the shares allocated to their account under normal ERISA vesting schedules.

Tax-Free Corporate Income
As advantageous as the above corporate tax benefits are, there are even more substantial tax advantages for an S-Corporation with an ESOP. The income attributable to S-Corporation stock owned by an ESOP is not subject to federal income tax. Most states mirror this provision. For example, If an S Corporation were 40% owned by an ESOP, then 40% of the company's income would be tax-free. If the company were 100% ESOP owned, then the company would pay no tax. This is not a deferral; the tax liability no longer exists.

Misconceptions
The ESOP as an option for liquidity and perpetuation planning is sometimes never seriously addressed due to misconceptions held by major investors, shareholders and/or their key advisors. An example of some of these misconceptions, and an explanation, are listed below.

1. ESOPs are a giveaway.
Explanation: ESOPs buy company stock at fair market value using corporate tax savings - with S-Corporation ESOPs the annual tax savings sometimes exceeds the amount of stock that is allocated.

2. Investors or shareholders lose control.
Explanation: Investors and/or shareholders and executives can maintain complete control.

3. ESOPS are for big companies.
Explanation: 50% of ESOPs are in companies with less than 100 employees. 80% of ESOPs are in companies with less than 250 employees.

4. You must disclose sensitive financial data to employees.
Explanation: There is no requirement to disclose corporate financial data, or executive compensation, just information regarding the ESOP, such as the value of each employee's account. The exception is for change of control transactions, which require a vote-pass through, which requires substantial disclosure.

5. ESOPs are forever.
Explanation: ESOPS can be bought out, terminated, or converted to a profit sharing plan.

6. ESOPs are for failing firms.
Explanation: 98% of ESOPs are installed in healthy firms.

7. Employees aren't interested in ESOPs.
Explanation: Quite the contrary, once employees understand the benefits, productivity increases. Studies show that ESOP companies are more profitable.

ESOP Research
Numerous studies have been done over the past 25 years demonstrating the productivity and performance of ESOP companies. Two examples are listed below.

Difference in Corporate Performance Post-ESOP vs. Pre-ESOP
Annual Sales Growth +2.4%
Annual Employment Growth +2.3%
Annual Growth in Sales/Employee +2.3%
Average Increase in Productivity +4.5%

Projected over ten years, an ESOP company with these differentials would be a third larger than a comparable non-ESOP company and would be two-thirds more valuable.

SOURCE: Rutgers University , Kruse and Blasi 1998.