ESOPs – The Ideal Vehicle for Buying Out a Minority Shareholder

July 2011Newsletters For Your Benefit

Traditionally, employee stock ownership plans (ESOPs) are used as a vehicle to facilitate the retirement of the sole (or majority) shareholder of a closely held corporation and to finance business acquisitions. However, ESOPs are sometimes the perfect (and often overlooked) financing vehicle for many other corporate transactions. For example, when structured properly, ESOPs can be the ideal vehicle to purchase the interest of a minority shareholder/investor.

ESOPs as a financing tool work particularly well if the company is a Subchapter C corporation, as the selling shareholder can take advantage of the tax deferral for ESOP rollovers under the Internal Revenue Code. In those cases, there are two principle reasons for the ESOP’s advantage over a simple buyout: (1) both principal and interest are fully deductable to the corporation; and (2) the selling shareholders pay zero tax on their gain if they engage in an ESOP rollover transaction. In such situations, there can be a 50 percent savings realized in the total cost of the transaction. These savings are best illustrated by the example set forth below.

Consider the following differences between a majority shareholder’s direct purchase of minority held corporation shares and his/her same purchase of shares through an ESOP, where the objective is to provide the selling shareholder with $10 million after taxes. In both cases, the corporation is the ultimate source of the funds. In the first instance, the investor/sellers pay no capital gains tax in a properly structured ESOP transaction. Assuming a combined 20 percent state and federal capital gains rate, in a private transaction, the selling shareholder/investor would need to receive $12.5 million to put him or her in the same after-tax financial position.

Further, assume that both the shareholder/purchaser and the ESOP will finance the transaction through an outside lender over a five-year period. Whereas the ESOP would need to repay $12 million (arbitrarily assuming $10 million principal and $2 million interest), the majority shareholder would repay $15 million ($12.5 million principal and $2.5 million interest) using the same assumptions. In the ESOP transaction, the net cost of the repayment to the sponsoring corporation is approximately $7.2 million over five years (assuming a 40 percent marginal corporate tax rate). By comparison, in a private sale, the corporation would have to pay a purchasing majority shareholder almost $21 million over five years in order to provide sufficient after-tax funds for him/her to repay the loan’s $12.5 million principal, plus $2.5 million to pay the loan’s interest (which is deductible and need not be “grossed up”). Thus, to equal the corporation’s expenses under an ESOP equity sale, it would have to provide the purchasing majority shareholder approximately $23.5 million at an after-tax cost of almost $14.1 million - almost twice as much as would be required using an ESOP transaction! The ability to achieve such extraordinary savings warrants commensurate efforts to structure the ESOP transaction as to allow it and its shareholders the advantages of these tax savings.

These savings are showing in the following table

Shareholder Purchase

ESOP

Cost of Shares $10,000,000 $10,000,000

Amount of proceeds necessary to provide same after tax value to selling shareholder/investor

$12,500,000 $10,000,000
Amount of proceeds required including financing costs: $15,000,000 $12,000,000
Bonus to majority shareholder to fund transaction including interest (over 5 years): $23,500,000 N/A
Contribution to ESOP including interest (over 5 years): N/A $12,000,000
After tax cost to the corporation: $14,100,000 $7,200,000

In order to realize the full benefits of the ESOP rollover, the selling shareholder must invest in “qualified replacement property” and sell at least 30 percent of the company to the ESOP while meeting several other technical requirements.
However, in most cases, the ESOP is economically superior to other financing arrangements, leaving these requirements palatable to the selling shareholder.

Undoubtedly, not every corporation or transaction is suited to be structured as an ESOP transaction. Generally, the ideal private company candidate for an ESOP will meet most of the following criteria: (1) strong cash flow; (2) history of increasing sales and profits; (3) consistently been in a high federal income tax bracket; and (4) substantial stockholder equity. The other attribute - that the company have strong management - is always satisfied in the case of a minority buyout.

Whether an ESOP is ultimately the right tool for a transaction largely depends on the specifics of the company and the contemplated transaction. However, the ESOP alternative always merits serious consideration based on the potential cost savings and tax advantages it presents.

For more information regarding this topic, please contact Harvey M. Katz at 212.878.7976 or [email protected] , or any member of the firm’s Employee Benefits & Compensation Planning Practice Group.