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By Allen P. Fineberg and Elliot D. Raff

ne afternoon, your client, FredSmith, calls for advice regarding apersonal business exit strategy.Fred, now 60 years old, has spent the last30 years building Fred Smith Industries,Inc., into a very successful business. Fredis the sole owner and has about 30employees, approximately $2 million of tangible assets and annual net earnings —before payment of Fred’s annual compen-sation of $300,000 — of $750,000.FSI manufactures and sells a highlyspecialized product that is only availablefrom a handful of other competing firmsin the country. Since these companies arebitter competitors, Fred is unwilling toapproach them to buy his business.However, FSI’s executive vice presidentJoe Miller, age 40, who has been with FSIfor 15 years, confided to Fred that hewould be interested in taking over thebusiness when Fred retires.Fred has confidence in Joe, but doesnot think he is ready to take over FSI byhimself, nor is Joe in a financial positionto pay the price that Fred believes FSI isworth.You mull over the situation for a fewminutes and suddenly a possible solutioncomes to mind — an employee stockownership plan. Now all you have to do isfind a way to sort out the alphabet soup soFred and Joe can understand the benefitsof an ESOPand how it can meet theirgoals.

ESOP Basics

An ESOPis a stock bonus plan that isa qualified retirement plan under theInternal Revenue Code and is designed toinvest primarily in qualifying employersecurities. See section 4975(e)(7).A“stock bonus plan” is essentially atype of profit-sharing plan in which distri-butions are intended to be paid in the formof employer stock. In addition, the defini-tion of an ESOPincludes a combinationof a stock bonus and a money purchaseplan, which was relevant under prior lawto increase the deductible contributionlimit from 15 percent to 25 percent; how-ever, now that the deduction limit forprofit-sharing and stock bonus plans hasalso been increased to 25 percent, this isno longer significant.As a “qualified plan,” similar to othertypes of qualified profit-sharing or pen-sion plans, an ESOPenjoys the three prin-cipal benefits of tax qualification underthe Internal Revenue Code: contributionsto the plan are currently deductible by theemployer when made; allocations to theparticipants’accounts are not taxed untilactually distributed; and the assets held intrust appreciate on a tax-deferred basis.Given these special features, pay-ments made by a corporation to fund anESOP’s stock purchase generally will betax deductible. In addition, an ESOPiseligible for special enhanced contributionand deduction limitations that are unavail-able to other types of qualified plans.Finally, if properly structured, the ESOPpurchase of Fred’s shares will be exemptfrom certain rules that otherwise wouldprohibit the transaction.As a result, an ESOPis a valuabletool not only for providing retirementbenefits (to an owner and employees), butalso for business and succession planningfor the employer and its principals.•

Qualifying employer securitiesdefined.

As noted, an ESOPmust be designedto invest primarily in “qualifying employ-er securities.” There are different statuto-ry definitions of qualifying employersecurities under Section 407(d)(5) of theEmployee Retirement Income SecurityAct and sections 4975(e)(8) and 409(l) of the code. However, for purposes of thisdiscussion we will focus on the morerestrictive code definition, because thetransaction must comply with that defini-tion in order for the ESOPto qualify forthe special tax advantages and transac-tional benefits described.If the employer’s stock is publiclytraded, then employer securities are com-mon stock issued by the employer (or anaffiliated company which is a member of the same controlled group) that is readilytradable on an established securities mar-ket. However, where there is no readily

Financial Planning

VOL. CLXXV – NO. 12 – INDEX 1176MARCH 22, 2004ESTABLISHED 1878

This article is reprinted with permission from the MARCH 22, 2004 issue of the

New Jersey Law Journal

Using ESOPs for Business and Retirement Planning

Fineberg is a shareholder and Raff isan associate in the employee benefits and business law practice groups at Flaster/Greenberg of Cherry Hill.

A powerful and flexible tool thathelps a retiring shareholder sellhis interest on terms favorable to him and the corporation

tradable common stock, i.e., no publiclytraded stock, then the employer securitiesrequired for ESOPpurposes is that classof common stock “having a combinationof voting power and dividend rights”which is at least equal to the class of com-mon stock of the employer having thegreatest voting power and dividend rights.In certain limited circumstances,noncallable preferred stock can qualify asan employer security, which may be heldby the ESOPif the stock is convertibleinto common stock, which meets the fore-going requirements. See section 409(l)(3).•

Investment primarily in employersecurities

.The requirement to invest “primari-ly” in qualifying employer securities hasnot been defined by the statutes or regula-tions, but it is generally understood, basedon an early Advisory Opinion issued bythe U.S. Department of Labor, that inorder to satisfy this requirement, at least asimple majority of the ESOP’s assets mustconsist of qualifying employer securitiesat all times.Although ERISAsection 404(a)(2)states that the diversification and pru-dence standards will not be violated bythe holding of qualifying employer secu-rities, the DOL(which has regulatoryauthority over ERISA’s fiduciary provi-sions) has taken the position in litigationthat under certain circumstances, theholding of employer securities, or at leasttoo large a portion of plan assets inemployer securities, could be imprudentand a breach of fiduciary duty, even foran ESOP, depending on the company’sfinancial condition, the valuation of thestock and similar factors.Recently, the DOLargued this posi-tion in its amicus curiae brief filed in theEnron ERISAlitigation on the long-stand-ing premise that ERISA’s prudence rulesapply to the acquisition, holding and saleof employer securities. See AmendedBrief of the Secretary of Labor Opposingthe Motions to Dismiss, Aug. 30, 2002,

Tittle et al. v. Enron Corp. et al.

, CivilAction 14-01-3913 and ConsolidatedCases (S.D. Tex).•

Other requirements

.As a qualified plan, an ESOPmustsatisfy most of the same rules that applyto profit-sharing plans, such as the mini-mum coverage and vesting requirements,nondiscrimination in contributions andbenefits, compliance with the top-heavyplan rules, etc.Adetailed discussion of these gener-al qualification rules is beyond the scopeof this article, although it is worth notingthat an ESOPgenerally may not be aggre-gated with other plans of the employer forpurposes of demonstrating compliancewith the coverage and nondiscriminationrules — although an existing plan can beconverted to an ESOP. However, there arealso several additional requirementsapplicable only to ESOPs:•

Stock distributions

.Participants can demand a distribu-tion from the ESOPin the form of employer securities instead of cash and, inthe case of securities that are not readilytradable, may require the employer torepurchase them. An ESOPis usuallydesigned to allow distribution to occur atretirement age, disability or terminationof employment.However, if the corporate charter orbylaws restrict stock ownership toemployees or to a qualified retirementplan — even if the restriction is onlyimplemented when the ESOPis adopted— or if the employer is an S corporation,the ESOPmay distribute benefits only incash. See section 409(h).This may be particularly importantfor S corporations, so that the S election isnot defeated by the corporation exceedingthe number of permitted shareholders.Note that distributions, whether in stockor cash, create a “repurchase liability,”which creates some additional planningopportunities. If shares are distributed andthe corporation buys them, it will not beable to deduct such an expense. If instead,the ESOPrepurchases the shares, therepurchase will be funded with a(deductible) contribution.On the other hand, if the ESOPrepur-chases the shares, these shares will bereallocated within the ESOP, with theeffect that they will be repeatedly repur-chased. Part of a study of the economicfeasibility of an ESOPis an analysis of projected repurchase liability.•

Pass-through voting

.An ESOPestablished by an employerwith registered securities must include aprovision allowing participants to votetheir ESOPshares.If the employer securities are not reg-istered, then the ESOPmust provide pass-through voting to participants only on cer-tain significant corporate matters whichrequire shareholder approval, such as acorporate merger, liquidation or sale of substantially all of the corporation’sassets. See section 409(e). Most impor-tant, the right to elect directors is notrequired to be passed-through.•

Diversification

.Participants who have reached age 55and completed 10 years of participationmust be given the right to elect, over a six-year period, to diversify a portion of theirESOPaccounts in up to three investmentoptions other than employer securities.This allows participants nearing retire-ment age to create a diversified, andpotentially less risky, portfolio.This can be accomplished by addingother investments to the ESOP(such as amoney market account and mutual funds)or by distributing assets to the participant.See section 401(a)(28)(B). The require-ment may also be satisfied by allowing aparticipant to transfer the amount eligiblefor diversification to another plan main-tained by his employer, which allowsinvestment direction.•

S Corporation ESOPs

.An S corporation can sponsor anESOP, effectively reducing (or eliminat-ing) the shareholders’current pass-through income tax liability (the liabilityis shifted to participants and deferred).However, there are additional rulesapplicable to S corporation ESOPs thatlimit the allocation of stock to theaccounts of certain “disqualified per-sons.” See section 409(p). Also, as notedbelow, certain special ESOPbenefits arenot available for an ESOPsponsored byan S corporation.

Valuable Tool

An ESOPhas special characteristicsunder the code and ERISAthat distin-guish it from other qualified plans, mak-ing it a uniquely valuable tool to use whenstructuring a redemption or buy-out of corporate stock in a tax-advantaged man-ner.•

Deferral of gain recognition

.An individual who sells stock in a Ccorporation to an ESOPmay be able todefer recognizing gain on the sale undersection 1042 if he invests the proceedsfrom the sale of the stock in “qualified

NEW JERSEY LAW JOURNAL

MARCH 22, 2004

175 N.J.L.J. 1176

replacement property” — generally secu-rities of a domestic corporation other thanthe employer that is engaged in the activeconduct of a trade or business — withinthe 15-month period ending one year afterthe securities are sold to the ESOP, pro-vided certain other conditions are satis-fied, as discussed below.•

Exemption from prohibited transac-tion rules

.Generally, the fiduciary of a qualifiedplan is not permitted to cause the plan tobuy or sell assets or engage in a loantransaction with a “disqualified person.”Both the employer that maintains the planand a majority shareholder of the employ-er are disqualified persons.However, special statutory exemp-tions allow an ESOPto engage in suchtransactions, in particular a loan transac-tion, provided it is “primarily for the ben-efit” of plan participants, is made at a“reasonable rate of interest” and satisfiesthe collateral restrictions mentionedbelow. See sections 4975(d)(3) and (13).This also allows a company to obtain abank loan and then lend the proceeds tothe ESOP.•

Increased deduction limit

.The maximum deductible contribu-tion to a defined contribution plan is gen-erally 25 percent of the annual compensa-tion of the participants. However, in thecase of a leveraged ESOP, the 25 percentlimitation applies to principal paymentsonly.There is an additional deduction forthe full amount of interest on indebted-ness incurred by the ESOPto acquirequalifying employer securities. See sec-tion 404(a)(9)(B). The additional deduc-tion for interest does not apply to anESOPsponsored by an S corporation.The deductibility of payments to anESOPreduces the effective cost of thestock purchase. For example, assuming acorporation has a 40 percent effective taxrate, it must have $1.67 of pretax earningsto make a one-dollar nondeductible stockredemption payment, but only one dollarof pretax earnings to make the samedeductible payment to the ESOP.•

Increased annual addition limit

.The maximum “annual addition” to aparticipant’s account in a defined contri-bution plan is the lesser of $41,000 or 100percent of a participant’s compensation.However, if no more than one-thirdof the employer contributions to an ESOPare allocated to highly compensatedemployees (this can be expresslyaddressed in the ESOPdocument), thenormal annual addition limits will notapply either to: (1) forfeitures — the non-vested portion of a participant’s accountforfeited upon termination of employment— allocated to other participants if theemployer securities being allocated wereacquired with the proceeds of an exemptESOPloan; or (2) any interest paid on theESOPloan which is deductible under sec-tion 404(a)(9)(B), as described above. Seesection 415(c)(6). As will be illustratedbelow, this provision allows higher thanordinary allocations and may be neces-sary for the ESOPtransaction to work.•

Dividend deduction

.If the employer declares a dividendthat is either distributed to participants orused to repay an ESOPloan, the dividendmay be deductible, even if it exceeds thenormal ESOPdeduction limit describedabove.However, dividends used to repay anESOPloan only are deductible if the div-idends are paid with respect to the sharesacquired with the loan being repaid andare used to repay the exempt loan, result-ing in a further allocation of shares to par-ticipants’accounts. See section 404(k). Itis worth noting that this is the onlyinstance in which corporate dividends aredeductible to the issuing corporation.

Structuring Fred’s Buy-Out With an ESOP

For Fred to understand how theserules work, it is best to present a specificexample to demonstrate how his buy-outmay be structured using an ESOP.First, you confirm some basic factsand assumptions.Given the current total of 30 employ-ees, and the turnover history, Fred esti-mates that if the ESOPrequires comple-tion of one year of service and attainmentof age 21 for participation, there will bean average of 25 participants, with totalcompensation of $1,250,000. Therefore,the 25 percent deduction limit will be$312,500, although Fred tells you that FSIexpects to have sufficient available cashto fund an annual contribution of up to$350,000.There will be a total of three “highlycompensated employees” participating inthe ESOP, including Joe (earning$200,000) and two other executives of FSI,each earning $100,000. None of Fred’sfamily members works for FSI.Accordingly, the amount allocable to high-ly compensated employees should be lessthan one-third, and the ESOPshould be eli-gible for the increased annual additionlimit under section 415(c)(6), as describedabove.FSI has only one class of stock, so bydefinition all of its shares are qualifyingemployer securities. There are 10,000authorized shares, of which 1,000 (allissued to Fred) are outstanding. FSI is notan S corporation.The company’s appraised fair marketvalue is $4,250,000. (In the case of anemployer whose stock is not publiclytraded, section 401(a)(28)(C) requires allvaluations of employer securities for planpurposes to be determined by an indepen-dent appraiser.) Since Fred is the onlystockholder, this amount is the total buy-out price for Fred’s shares.As noted above, Fred is not yet readyto retire and he does not think Joe is readyto run the business by himself. Fredagrees to your suggestion of a five-yeartransition period, during which the ESOPcan begin buying Fred’s stock and Joe cangradually be given more executiveauthority.

1042 Treatment

Since Fred will still work (andreceive substantial compensation) for atleast the next five years, he wants to deferrecognition of the gain on the sale of hisstock until he retires (if not longer). Inorder to do this, the transaction must meetthe requirements of sections 1042 and409(n). As noted, within the year follow-ing the stock sale, the proceeds must beinvested in qualified replacement proper-ty.Immediately after the sale, the ESOPmust hold at least 30 percent of FSI’s out-standing stock (i.e., 300 shares) and gen-erally cannot dispose of such shares forthree years. Perhaps most significant, for10 years after the completion of the saleof Fred’s stock, no portion of the ESOP’sassets can be allocated to Fred (or certainmembers of his family) or to anyone whoowns more than 25 percent of the FSI

175 N.J.L.J. 1176

NEW JERSEY LAW JOURNAL

MARCH 22, 2004