Fortunately, with an employee stock ownership plan (ESOP), a business owner can achieve liquidity and diversification and possibly defer or eliminate capital gain tax (while retaining control) by using deductible dollars as the purchase price.

An ESOP is not only a tool to achieve liquidity, but also a way to finance a buyout or acquisition, or a way for management to acquire an equity interest. Although it appears simple, an ESOP is really a complex web of tax, legal, financial and other technical components. In determining whether one is feasible, a tax adviser has to develop a clear sense of a business owners goals, as well as the goals of the others involved (including the management team, employees, selling and nonselling shareholders and even lenders providing capital). To accurately define goals, parties to an ESOP transaction should determine the amount of stock to be purchased, the number of plan participants, the companys debt-carrying capacity for a leveraged ESOP, plan provisions, voting rights and the trustee selection process.

Alhough ESOPs are unique in many ways, they share most of the common characteristics of other employee benefit plans. For example, Sec. 401(a)(28)(C) requires that an ESOP purchase stock at its fair market value (FMV), as determined by an independent appraiser usingadequate consideration andfairness standards. Thus, a preliminary valuation is a key first step in any feasibility study.

Feasibility: All successful ESOPs have undergone a feasibility analysis, whether formal or informal. However, even a promising study does not guarantee success. A preliminary valuation does not satisfy all of the necessary requirements to defend the stocks FMV before the IRS or the Department of Labor (DOL); rather, it is a cost-efficient method of determining the underlying economics of the proposed ESOP and a companys value. This value readily determines who will sell, who will buy and at what price. If the ESOP proves feasible, the valuation firm would provide a formal valuation opinion for the stock transaction between the ESOP and the selling shareholders; often, this opinion is an update of the preliminary study. The final valuation would complete the due diligence needed to meet the Services and DOLs consideration and fairness standards.

A general misconception pertains to both employee control and disclosure of financial matters: employees do not vote to select board members, nor are they required to receive financial information. Each participant is, however, entitled to direct voting of the shares allocated to his or her account for any of the following corporate mattersmerger, consolidation, recapitalization, reclassification, liquidation, dissolution and a sale of substantially all of the businesss assets.

Under Sec. 1042, if shareholders of a closely held C corporation who have held their stock for at least three years, sell that stock to an ESOP, they can defer gain recognition on the sale in certain circumstances. For the sale to qualify for a Sec. 1042 rollover, under Sec. 1042(c)(3), the sellers must purchase qualified replacement property (QRP) within 12 months after the sale.

Sec. 1042(c)(4) defines a QRP as securities issued by a U.S. operating company; such instruments include common or preferred stock, corporate bonds or notes, convertible bonds or floating rate notes. According to Sec. 1042(b)(3)(B) and (c)(6), the sellers must file a notarized statement with the IRS describing the QRP, no later than their return filing deadline (including extensions) in the year in which the transaction took place. They must meet certain requirements for both the securities and the timing of the investment; see Puckett, Tax Clinic, No Gain Deferral on Stock Sale to ESOP, this issue.

If shareholders elect a Sec. 1042 rollover, they are precluded from receiving a stock allocation under the ESOP. As a result, they could lose retirement benefits, which could only be continued under the employers other retirement plans. The company could create nonqualified retirement plans to replace any benefits lost by adopting the ESOP.

Although an S corporation may also adopt an ESOP, under Sec. 1042(c)(1)(A), S shareholders cannot use a Sec. 1042 rollover. S corporations considering ESOPs should weigh this limitation. However, there are other tax benefits. For example, if an ESOP owns part or all of an S corporation (a SESOP), it will not be currently taxed on the income attributable to the portion of the S stock that the ESOP owns.

A leveraged ESOP can use corporate credit to finance the stock purchase. This, more than any other feature, distinguishes an ESOP from all other qualified plans.

To facilitate loan repayments by leveraged ESOPs, under Sec. 404(a)
(9)(A), C corporations can make deductible contributions of up to 25% of covered participants compensation that can be used to repay the loans principal. Contributions used to repay loan interest are generally also deductible, under Sec. 404(a)(9)(B). Sec. 404(a)(9)(C) disallows this deduction for SESOPs.

Importantly, covered compensation is not always the same as total compensation, as it is unlikely that all employees can be included in the ESOP. New employees who have not met the eligibility requirements, or employees covered under a collective-bargaining agreement, may not be eligible to participate.

Dividends paid by the sponsoring corporation help repay the loan and can effectively expand the 25% limit. They are often used when the ESOPs compensation base is inadequate. Dividends do not count toward the 25% deduction limit described above, or the individual allocation limits under Sec. 415.

C corporations can deduct dividends paid on ESOP-held stock. Under Sec. 404(k), generally, they can deduct cash dividends used to make payments on an ESOP acquisition loan, or paid in cash directly to an ESOP participant or as payments to the ESOP and then distributed to participants. If dividends are used to make loan payments, released shares attributable to dividends would be allocated to participants on the basis of account balances or using a combination of balances and eligible compensation.

Company contributions to other retirement plans may also reduce the amount that can be contributed to the ESOP, dollar for dollar. If there is insufficient payroll or the company wants to maximize ESOP contributions, it may consider reducing contributions until the ESOP loan is repaid, freezing benefits or even terminating plans.

Ultimately, the cash needed to satisfy ESOP obligations must come from the sponsoring company. Thus, paying off ESOP obligations puts two added burdens on a company: (1) buying out owners and (2) repurchasing the shares of vested employees on termination. If a company is having financial difficulties, it probably cannot afford to implement an ESOP. Lenders are not generally keen on providing funds if they question a companys cashflow. Cashflow can be managed, provided it is planned for in the initial stages of the feasibility study.

The ESOP solution makes simple financial sense for many, but not all, companies. In the end, if an ESOP is properly planned with structure as a priority, management will have the tools to anticipate any obstacle to successful implementation and to maximize the ESOPs objectives. No matter the reasons for considering an ESOP, sales of company stock to an ESOP are an excellent way to partially or completely diversify interests in a closely held business.