No fable: ESOP a great incentive for employees

What is an ESOP? No, it’s not a fable, that was Aesop. The acronym stands for Employee Stock Ownership Plan. But, during this financial downturn, you might want to think of it as an Economic Stimulus Offering Possibility —- the possibility to inspire employee loyalty and provide liquidity for your company (or you), all while enjoying significant tax breaks.

An ESOP is a tax-qualified retirement plan designed to borrow money and use the proceeds to buy stock of the sponsoring employer on a tax-advantaged basis. In other words, it enables employees to own stock in their employer. Unlike other qualified retirement plans, like a 401(k), an ESOP is required to invest primarily in the sponsoring company’s stock.

While the Southeast has not seen a proliferation of ESOPs, it has its fair share. Such plans have been quite popular in other parts of the country for some time because of their powerful tax advantages.

For example, a shareholder who sells his or her stock in a privately held company may defer all of the taxable gain on the sale, provided he or she reinvests the sales proceeds in “qualified replacement property.” That basically means debt or equity securities of any U.S. operating company.

The use of an ESOP may allow a corporation to deduct dividends paid to the ESOP. An ESOP can also be used as a tool of corporate finance, allowing the corporation to deduct debt service on corporate borrowings.

Recently, ESOPs received a major boost through the change in the Internal Revenue Code allowing ESOPs to be a shareholder of an S corporation. Basically, all of the income of the corporation that is allocated to the ESOP, as an S corporation shareholder, is not taxed —- a powerful economic advantage. If the ESOP owns 100 percent of the stock of an S corporation, none of the income of the corporation is taxed. The tax savings can be used to pay the debt incurred by the ESOP to buy the stock.

ESOPs can be an effective weapon for combating the economic crisis. In fact, ESOPs are one of the few ways to raise capital during a recession. They also shield you from the volatility of the markets by keeping your company private.

Family-owned businesses, especially companies owned by baby boomers who want to “get liquid” as they approach retirement, are good candidates for ESOPs. They offer an alternative to selling the company outright to a third party; owners can still “sell” their business and gain much needed cash while staying in place —- often a preferred route to an orderly succession.

ESOPs also keep companies local rather than selling out to national or international entities. Indiana recently incentivized, through a “linked-deposit” program, the establishment of ESOPs as a means of boosting the local economy. State Treasurer Richard Mourdock explains, “ESOPs have a clear track record of creating wealth, encouraging entrepreneurial attitudes, and increasing productivity.”

Because ESOPs are advantageous financing tools, they can be used in almost any industry. This includes highly regulated fields like financial institutions, insurance companies, accounting and health care firms. ESOPs are flexible; they can be structured a variety of ways to achieve the owner’s goals.

When they are formed, ESOPs often encourage the company to award equity to key management employees in exchange for a commitment to remain with the company and achieve reasonable financial performance over the long term. Thus, for little or no cash outlay, and without affecting the price paid to selling shareholder(s) for their stock, key management can earn a significant equity interest in their employer —- in addition to their ESOP benefits.

Perhaps the most overlooked benefit of ESOPs is their potential effect on employees. Several studies have shown that, when properly communicated, ESOPs result in “employee-owner” attitude and behavior. Over time, this results in increased productivity and efficiency and higher stock value.

Some employees even enjoy the increased personal wealth. And if that’s not motivating during a recession then nothing is. You may even think of it as the perfect incentive program for your employees. And that’s no fable.

> Stephen G. Smith is the managing partner of the Atlanta offices of the Krieg DeVault law firm and has been responsible for structuring more than 175 ESOP transactions for public and private companies nationwide.