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| ESOP and Philanthropy | |
INDEX: 1. Overview 3. Benefits for Private Owners
4. Case Studies
PRIVATE BUSINESS OWNERS?
As stated earlier in this discussion, the ESOP provides owners of closely-held businesses with both a value for the stock they hold in their companies and a ready market for those securities. But that is only the beginning. The ESOP also provides significant tax and financial incentives for owners and companies. Moreover, its implementation can resolve problems relating to business succession and transition, estate planning and, finally ESOPs can help to facilitate charitable contributions.
One of the most significant of the tax incentives was created in the Tax Reform Act of 1984.
The Tax-Free Rollover: Under this provision, a taxpayer may defer paying any federal income taxes on the sale of closely-held stock from a privately-held C corporation to an ESOP, provided that he reinvests the proceeds in qualified replacement securities within twelve months of the date of sale.
In order to qualify for this deferral, the shareholder must sell closely-held domestic company stock that he has held for three or more years . . . Secondly, after the transaction is complete, the ESOP must own at least 30% of the total value of all outstanding company stock . . . [Finally] the funds must be reinvested in qualified replacement securities within a period beginning three months before the sale and ending 12 months after the sale. (John D. Menke, ESOPs Pros and Cons [San Francisco: Menke & Associates, Inc., 1990], p. 2.)
An ESOP rollover may be attractive to a selling shareholder for a number of reasons. Normally a retiring owner can either: A) sell his or her shares back to the company, if such a transaction is feasible; B) sell to another company or individual if a willing buyer can be found; or C) exchange a controlling block of stock with another company. Selling to an ESOP, on the other hand, allows the selling shareholder to sell all or only a part of his or her stock and defer taxes on the gain by reinvesting the proceeds in "qualified replacement property"--generally, the stocks and bonds of domestic operating corporations. . . . In addition to the favorable tax treatment, selling to an ESOP also preserves the company's independent identity, while other selling options may require transferring control of the company to outside interests. A sale to an ESOP also provides a significant financial benefit to valued employees and can assure the continuation of their jobs.
In the case of owners retiring or withdrawing from a business, an ESOP allows them to sell all or just part of the company and withdraw from involvement with the business as gradually or suddenly as they like. (The ESOP Association, How the ESOP Really Works, [Washington, DC: The ESOP Association, 1992] pp. 26-27.)
Investment Diversification: Previously, the only way in which an owner of a closely-held company could achieve investment diversification without incurring an immediate income tax was to engage in a tax-free merger with a public company. In order to qualify for a tax-free merger, however, an owner must transfer 80% or more of his stock in exchange for public company stock. In effect, the owner has to give up control. Moreover, he still has no investment diversification.
Under the ESOP rollover provision, these problems are avoided. In order to get tax-free treatment, the ESOP need only acquire 30% ownership, and the replacement securities can be fully diversified . . .
Capital Gains: An ESOP can also be used to lock in the capital gains tax rate. If, for example, a shareholder wishes to sell less than 30% of his stock, or wishes to invest the proceeds in investments other than "qualified replacement securities," he may sell part or all of his stock to the ESOP and elect capital gains treatment. As a result, he will be taxed at the 20% rate, even if he retains significant stock ownership. (John D. Menke, ESOPs Pros and Cons, pp. 3-5.)
While the topics of transition and succession should be high priority agenda items for owners of closely-held businesses, the sad fact is private business owners tend to defer or avoid consideration of these issues altogether. Their reasons for doing so, however, are very understandable.
In 1991, a major accounting firm surveyed its family-run and closely-held business clients and discovered that only 10 percent had succession plans in place. The survey also revealed that only 1 percent had adequately funded such plans. Given their understandable preoccupation with the day-to-day struggles of normal business operations, owners typically spend very little time developing and/or implementing plans to assure a smooth transition of ownership to the next generation. Yet, we would point out data secured from the United States Department of Labor seem to suggest that 70 percent of family-owned and closely-held businesses fail to survive from one generation to the next.
ESOP installation can address and resolve each of the enumerated problems. Because the ESOP creates a market for the owner's privately-held stock, the owner can opt to liquefy only that portion of the equity in the business he requires to fund his retirement needs. The ESOP, thus, resolves the problems associated with the owner's need for a steady and dependable source of income. Insofar as "letting go" is concerned, the ESOP Trust into which the owner conveys the company-owned stock is governed by an ESOP Committee. Regulations governing the operation of the ESOP permit the owner to sit on that committee and, thus to retain control even though he has sold a portion of his company-owned stock to the ESOP Trust. Finally, insofar as family members are concerned, because of the market-making capabilities of the ESOP, those family members who own a minority interest in the enterprise, now have a ready market for their shares.
ESOPs can play a vital role in estate planning:
The ESOP is especially attractive for principal shareholders [of closely-held companies] who have "excess stock ownership." For example, assume a corporation is 100% owned by a shareholder who is in his early 50s. Such a shareholder has "excess stock ownership," in that he does not need 100% ownership in order to maintain control. Moreover, unless this stock can be sold for cash, these securities represent nothing more than an estate tax liability. By installing an ESOP, such a shareholder can sell his excess stock ownership to the ESOP Trust over a period of years, or if he prefers he can gift the excess. (John D. Menke "ESOP: Pros and Cons of a New Type of Corporate Finance Plan," Reprinted with permission from Doors and Hardware [San Francisco: Menke & Associates, Inc., 1990] p. 1.)
Because of its market-making capability, the ESOP can facilitate both outright and planned contributions to non-profit and tax-exempt organizations. As we stated at the outset, the ESOP creates the market for and establishes the value of privately-held stock. Moreover, as the section on Tax and Financial Incentives for C Corporations makes clear, ESOP legislation includes significant tax incentives designed to encourage private business owners to install ESOPs.
Outright Contributions of Stock: Just as the ESOP functions as a market-maker for those business owners who own non-publicly traded stock in an ESOP company, the ESOP can also function as a market maker for those charities to whom an owner may want to gift such securities. For example, a shareholder could gift shares of non-publicly traded stock directly to the charity. In turn, the charity could immediately opt to liquefy this gift by selling the shares back to the company's ESOP. Alternatively, (assuming the ESOP now holds 30% of the company's outstanding shares) the owner could sell additional shares of his closely-held stock to the ESOP, purchase qualified replacement securities tax-free and gift those replacement securities to the charity.
Private Foundations and the Tax-Free Rollover Provision: The ESOP can also facilitate a company owner's desire to set up a private foundation. Regulations governing private foundations generally prohibit the owner of a closely-held business from contributing privately-held securities directly to a private foundation. However, under the tax-free rollover provision, as previously mentioned, this problem can be avoided. The owner may sell his closely-held securities to the ESOP and reinvest the proceeds tax-free into publicly-traded securities. He can then transfer the securities to a private foundation without violating the rules regarding the acquisition and holding of employer securities.
In order to clarify how effectively the ESOP can work to facilitate charitable contributions we have included two case studies in a latter portion of this document.
At this juncture, it might be appropriate to include a brief discussion of redemptions as an alternative method of handling gifts of privately-held stock. In this situation rather than advocating ESOP installation to a prospective donor of closely-held stock, the charity might simply suggest that the donor's company arrange to repurchase any shares of privately-held stock which had been gifted to the charity. In a 1978 revenue ruling, the IRS indicated that it would not treat a redemption of stock given to charity as gain or income to the donor unless the charity was legally bound, or could be compelled by the corporation to surrender the shares to the corporation. In our opinion, however, the issue is not so much one of legality as it is the cost-effectiveness for both donor and charity.
Putting aside for a moment the question of whether the company treasury would have sufficient cash resources on hand to fund such a charitable gift redemption, there are a number of other issues which also come to bear on this course of action.
Valuation: The IRS requires that any gift in excess of $10,000 must be professionally appraised to document value. In the exercise of their "do diligence" appraisers must take the nature of the security into account. In general, because of the lack of a ready market for closely-held stock, these securities sell at substantial discounts. A 30% to 60% reduction is not uncommon. Appraisers must factor this into their decision-making.
Tax Consequences: One of the more important tax incentives which ESOP legislation allows is the purchase of closely-held stock by the ESOP with before rather than after tax dollars. Depending upon the company's tax bracket, repurchase of gifted stock by an ESOP could result in substantial savings for the corporation.
In our opinion it is far more cost effective for donor, charity and the company's perspective if gifts of privately-held stock are handled via an ESOP transaction, rather than with a redemption.
ESOPs bear some similarity to profit-sharing plans, and sometimes these employee benefit programs can be confused with one another. However, there are major differences between these defined benefit plans, and perhaps the best way to document the very positive impact that ESOPs can have upon employees is to compare the two.
From an employee standpoint, the ESOP is almost always a better incentive than is a profit-sharing plan. The philosophy of a profit-sharing plan is that if the company makes a profit, a portion of this profit will be shared with the employees, and the employees will thereby have an incentive to maximize company profits. In theory this sounds workable. In practice it is not. In fact, most companies report that little or no employee incentive or motivation is generated as a result of profit-sharing contributions. The difficulty is that profit-sharing plans are not tangible, and there is no direct link between employee productivity and employee benefits under such a plan. Under a profit-sharing plan, the share of the profits contributed to the plan is invested in a hodgepodge of investments rather than in company stock. These other investments have little or no meaning to most employees, and most employees have little or no awareness [about] how these investments do in the market-place. Profit-sharing investments wind up being too amorphous and too intangible.
Investment in stock of the employer is exactly the opposite. The employer stock is tangible and immediate. The employee can see, touch and feel his own company. Owning stock of his own company gives an employee a new sense of dignity, a new status, and a new awareness of the pride of ownership.
More important, however, is the fact that investment in employer stock creates a direct link between employee productivity and employee benefits. In a profit-sharing plan the value of the investments usually bears no relationship to employee productivity. In some instances, employee productivity remains high or even increases [while the value of the securities held in the profit-sharing portfolio plummets]. Conversely, the value of the investments in a profit-sharing plan may soar as a result of favorable market conditions at the very same time employee productivity is going from bad to worse. In an ESOP, on the other hand, the value of the investment bears a direct link to employee productivity. Further, unlike a profit-sharing plan, employees under an ESOP will be able to affect the value of the investment to a large degree by their own efforts. (John D. Menke, ESOPs vs. PROFIT-SHARING PLANS [San Francisco: Menke & Associates, Inc., 1987], p. 1.)
ESOPs can also save jobs for valued employees. Virtually all of the other alternatives which permit an owner to cash out equity require the owner to relinquish some measure of control in exchange for liquefying his assets. By so doing, the owner can leave valued employees at risk of such undesirable eventualities as transfer, demotion or even involuntary separation from the company. With an ESOP the owner maintains control; thus he can preserve the status of his employees and continue his relationships with these valued business colleagues.
IN GENERAL, HOW DOES A COMPANY BENEFIT FROM AN ESOP?
The ESOP provides an important tax benefit for companies which have installed this plan:
Dividend Deduction: The 1984 Tax Reform Act amended 404 of the Internal Revenue Code to provide for the deductibility of cash dividends paid to an ESOP, provided that the dividends are passed through in cash to plan participants within 90 days of the end of the tax year. In the alternative, the dividends may be paid directly to the participants without first being paid to the plan.
The purpose of the dividend pass-through provision is to provide greater employee incentives by enabling the participants to realize current income from the plan. [Moreover], the payment of a cash dividend [is a tangible incentive which, in many cases, can have] a dramatic effect on employee motivation. (John D. Menke, ESOPs Pros and Cons, p.5.)
In terms of finances, from the company's perspective, an ESOP sale draws upon pretax cash flow. Thus an ESOP provides an inherently [34 percent plus state tax] less expensive way for the company to cash out an owner. Virtually all of the other alternatives that allow an owner to cash out equity draw upon after-tax cash. If, for example, stock is redeemed by the company, the repurchase is made with after-tax dollars from the company's treasury. By using an ESOP, the company acquires an in-house market which enables these shares to be repurchased with tax-deductible dollars. As a result of installing the ESOP, the company establishes a funded business succession plan, and the owner or other shareholders do not have to die in order to liquidate their holdings.
As we explained in a previous section of this pamphlet, ESOPs bear some similarity to profit-sharing plans. They differ from profit-sharing and all other defined contribution plans in that ESOPs are allowed to borrow money.
To date most ESOP loans have been used primarily as a means of facilitating a tax-free rollover transaction. However, an ESOP loan can also be used to acquire newly issued stock from the company, to finance a taxable transaction or to finance a leveraged buyout transaction in which an ESOP acquires part or all of the stock of the acquired company.
The ESOP also fosters productivity; moreover, it does so in a synergistic fashion. Since the inception of the ESOP concept there have been a number of studies concerning the overall impact of these plans on company performance. The results of these analyses suggest rather strongly that when the ESOP is combined with policies designed to encourage meaningful employee involvement in company operations, ESOP companies tend to be demonstrably more profitable and more productive than their non-ESOP counterparts. The results of the first of these studies undertaken by Corey Rosen and Michael Quarrey were published in 1987 in the September-October issue of the Harvard Business Review. The authors indicate concerning their study which was controlled for industry-wide variables:
We have found . . . that ESOP companies grow fastest when ownership is combined with a program for worker participation. A synergy emerges between the two: ownership provides a strong incentive for employees to work productively and opportunities for participation enhance productivity by providing channels for workers' ideas and talents....
The results of [our] analysis proved [to be] striking. During the five years before instituting their ESOPs, the 45 companies [we included in our study] had, on average, grown moderately faster than the 238 [non-ESOP] comparison companies: annual employment growth was 1.21% faster and sales growth, 1.89% faster. During the five years after these companies instituted ESOPs, however, their annual employment growth outstripped that of the comparison companies by 5.05%, while sales growth was 5.4% faster. Moreover, 73% of the ESOP companies in our sample significantly improved their performance after they set up their plans. (Corey Rosen and Michael Quarrey, "How Well Is Employee Ownership Working?," Harvard Business Review, September-October, 1987, No. 5 [Cambridge, Mass.: Harvard University Press], pp. 126-127.)
In a pamphlet authored in 1993 by Laurence G. Lyon entitled The PRO -- Productivity SystemTM, Mr. Lyon excerpted a portion of an oral presentation made at the 12th Annual Convention of the ESOP Association by Corey Rosen. Mr. Rosen reported as follows:
When ESOP companies encouraged more employee participation they increased their growth differential to 8 -11% more than non-ESOP companies in the same industry. [Mr. Lyon went on to comment:] As a result, shareholders end up owning a smaller piece, but of a much bigger pie. (Laurence G. Lyon, The PRO -- Productivity System TM [San Francisco: Menke & Associates, Inc., 1993] pp. 3-4.)
More recently, Baron's published an article on December 5, 1994, entitled "The Participation Equation: Which Plan Makes Workers Work Best?" The article referenced several management theories including Theory O, about which it said:
[The National Center for Employee Ownership] describes Theory O as a corporate culture in which workers have both rights and responsibilities. As workers holding stock in the corporation, they have the right to a share of the profits. But as stockholders, they also have the responsibility to make sure that the decisions affecting their working lives are made wisely and well. (Gene Epstein, "The Participation Equation: Which Plan Makes Workers Work Best?," Baron's, December 5, 1994.)
The article goes on to state:
The General Accounting Office found a very strong correlation between high productivity and worker-owned companies that combined that ownership with mechanisms for worker participation. For these firms, these factors produced a 2% higher productivity growth per year than they would have otherwise had. The National Center for Employee Ownership . . . found that over a ten-year period, companies with significant worker ownership grew 40%-46% faster than they would have without worker ownership. (Ibid.)
Given its versatility and its strengths in providing both a multifaceted array of financial tools for company owners and powerful benefits and incentives for employees, the ESOP has become a very valid alternative for an increasing number of closely-held companies. From a charity's point of view, assuming that you are dealing with a prospective donor whose company qualifies for ESOP installation, the ESOP can also help to facilitate major philanthropy.
If an owner of a closely-held business is wealthy enough to consider (or he is being encouraged to consider) significant philanthropy to your institution emanating from the equity in his privately-held company, it stands to reason he may also be wrestling with other issues related to business succession, wealth transition, and/or a combination of those factors.
The chances are that your planned giving office is probably doing a good job of stressing the importance of transition planning in the materials it disseminates and the presentations it makes about this issue. However, if your organization's fund-raising executives do not have an in-depth understanding of the role the ESOP can play in facilitating transition for and securing philanthropy from owners of closely-held businesses, your organization may be missing critical opportunities to secure major gift income from a sizable portion of the profit making sector.
In light of the foregoing, we would suggest that there are some very valid reasons that fund-raising executives need to learn more about ESOPs. More to the point, we believe there are instances when it would be very much in the "enlightened self-interest" for both a prospective donor and a charity, if the charity were to strongly advocate ESOP installation for those prospective donors who qualify for this Plan. We also believe that ESOP advocacy should become as comfortable and as routine for your organization as has been the case for any of the other trusts currently referenced in materials and presentations created by your organization's planned giving office.
Since 1974, Menke & Associates has provided financial counseling for our clients. We have installed more ESOPs than virtually any other service provider in the country. We would be pleased to provide competent and confidential counsel to any of your prospective donors who may be wrestling with decision-making about issues such as liquefying business assets, transition succession or major philanthropy.
Index
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