Fact or Fable? ESOPs for Family Businesses

As published in Nashville Business Journal.

In 1986, HCA sold 30 of its hospitals to HealthTrust, which used a leveraged employee stock ownership plan to raise most of the required capital. Ten years later, HealthTrust was bought back by Columbia/HCA, creating a large amount of retirement assets for the company employees.

The same ESOP arrangement used by HCA also can be used to help with the ownership transition process of much smaller, incorporated family businesses.

An ESOP is a special type of tax-qualified defined contribution retirement plan - much like a 401(k) plan - that invest primarily in employer securities, usually the common stock of the plan sponsor. It can consist of both stock bonus and money purchase pension plans.

An ESOP may borrow funds to purchase employer securities from any number of sources. The employer can directly provide stock or cash used to buy stock. The ESOP also could borrow money from the plan sponsor or existing shareholders, giving it the necessary liquidity to buy the stock of departing shareholders. This is often on a tax-advantaged basis that allows the selling shareholder to defer and possibly avoid paying long-term capital gains taxes.

There are several special tax incentives that encourage both corporations and departing shareholders to consider using an ESOP. "C" corporations can deduct ESOP contributions of up to 25 percent of covered payroll and all contributions used to repay interest expense. "S" corporations also can deduct 25 percent of covered payroll, but can't use the special interest expense rule.

When the covered payroll of a "C" corporation is too small to meet the required repayment schedule on a proposed ESOP, the business can deduct any reasonable dividends that are paid on the ESOP stock and create an opportunity to provide additional funds to an ESOP. However, "S" corporations can't use this special rule.

A "C" corporation shareholder who sells stock owned for three years to an ESOP may elect to defer the payment of capital gains from the sale.

To elect this special treatment, the ESOP must own at least 30 percent of each class of the employer's stock after the purchase.

The selling shareholder also must reinvest the sale's proceeds in qualified replacement property such as stocks and bonds during a specified time. This deferral opportunity can make an ESOP a "most favored buyer" for elderly "C" corporation shareholders who would otherwise avoid capital gains tax on the sale of stock simply by holding their shares until death.

However, there are complications to be addressed in evaluating the usefulness of an ESOP for a particular family business. First, there are limits on how much ESOP debt can be serviced in an ESOP, generally limited to 25 percent of the company payroll.

When ESOP stock is distributed, the employee can elect to have the company repurchase the distributed shares during the first 60 days following the distribution or during a 60-day period in the next plan year. This repurchase liability requires careful study and planning.

Finally, the corporation is almost always required to guarantee ESOP debt. It must either have assets to secure such debt or the selling shareholders must provide security for the lender through a guaranty or a pledge of other assets, often the qualifying employer securities purchased with the sale's proceeds.

This is a brief summary of a very complex topic. However, family business owners and their advisors need to be aware of the possible uses of an ESOP as part of any ownership transition plan.