Sometimes logic doesn’t make sense. And sometimes the illogical is the real deal.
While talking to an ESOP expert the other day, I came to the realization that a lot of features of employee stock ownership plans don’t make sense on the surface. And yet that’s what makes them such a compelling finance, retirement and exit tool for business owners. If you will, follow my (il)logic.
Illogic #1: The tax code is your friend. Much in the Internal Revenue Code is ambiguous, and so tax advisors expend a lot of time figuring out ways to legally avoid the intended outcome of the provisions. Why else would we have planning tools with names such as the “Intentionally Defective Irrevocable Trust”? With ESOPs, however, the tax advantages are clear, and Congress apparently wants business owners to leverage these advantages.
To review, an ESOP is a qualified retirement plan funded primarily with the sponsoring company’s stock. To encourage private business owners to “share the wealth” with their employees through company stock ownership, the ESOP provisions have three key tax advantages. First, under certain circumstances, the owner of the stock can sell the stock and defer the gain. Second, assuming the funding of the ESOP was accomplished through borrowing, effectively both the interest and principal payments on that loan are deductible. Finally, assuming the company is (or becomes) an S Corp, income generated inside the ESOP is free from federal income tax. These positive outcomes do not come from gaming the Tax Code – they’re intended by Congress, and have been for nearly 40 years.
Illogic #2: You can borrow to fund your pension. Unlike a typical qualified plan, with an ESOP it is permissible to borrow the funds needed to finance the plan. Historically, companies would use their good credit to secure a loan from a bank. This loan would in turn be lent to the ESOP, and those funds would be used to purchase the owner’s stock. Because the ESOP primarily secures funds for payment of the loan servicing through employer contributions to the qualified plans, the expense is deductible to the company – a win-win for both the employer and the bank. I’m told that because of the economic downturn, ESOP administrators are more frequently seeing the stockowner taking the position as the lender. In other words, the business owner finances the sale of his or her own business by selling to an ESOP. As the loan is paid off, the owner is moving eggs from all one basket (the business) to a diversified portfolio. In a time when financing can be difficult, ESOPs offer the possibility of flexible funding approaches with bank and seller financing.
Illogic #3: The best way to keep your business is to sell it. Many business owners I know fit the definition of “control freak.” Their business continuation plans can be captured in four words: “Cash Now; Exit Later.” An ESOP may work as a financing plan for these owners. For one thing, they don’t necessarily have to sell a controlling stake in their businesses. Even if they do sell a majority interest, that doesn’t necessarily mean loss of control. The ESOP stock is held in trust in the qualified plan, and if the business owner also runs the business, he or she has fiduciary duties in selecting and monitoring the trustee. Further, the financials of the company are a matter for the plan trustee’s knowledge and review; they don’t have to be subject to the day-to-day scrutiny of plan participants. A final consideration is that the plan participants share in the beneficial interest but not the equity of the business until the financing is paid off. As each loan payment is made it unencumbers shares, which are then allocated.
Illogic #4: 1 percent plus 99 percent = 110 percent. As the “Occupy Wall Street” movement demonstrates, people feel disenfranchised when they have no say in how wealth is handled. When Congress created the ESOP rules, it had a positive outcome in mind. An employee-owner is more engaged and productive than a mere employee. I’ve seen this behavior manifested in many an interaction with an employee-owned company I frequent. The employee’s position may be menial, but that person is an owner.
With an ESOP-owned company, there is no requirement that the company be egalitarian with its fortunes or its salaries. Pay for performance is still the rule. The distinction is that an ESOP allows the rank and file – the 99 percent - to feel a sense of participation in the company’s wealth. A successful company translates into a well-funded retirement account for the employees.
This thinking may or may not be logical, but then again, who says owners or their employees have to be logical?
