There is a reason that employee stock ownership plans (ESOPs) occupy this particular place in this book, somewhere between “what doesn’t work” and
“what does work.” ESOPs offer a unique opportunity, to be sure, but it is an approach that doesn’t work well for a lot of advisors and for various reasons. After you learn more about this avenue, we’ll share our conclusion and observations at the end.
The term employee stock ownership plan was fi rst defi ned by federal legis- lation in the Employee Retirement Income Security Act (ERISA) of 1974. That makes an ESOP a relatively new form of plan that has been in existence only since September 2, 1974, when ERISA was enacted into law. Yes, when you enact an ESOP, you add one more federal regulator to your list (the U.S. Department of Labor)—not a reason to dismiss this planning strategy, but something many of our clients think about in an already highly regulated industry.
Many ESOPs existed prior to 1974, even though such plans were not defi ned by federal statute. Employee stock ownership plans were fi rst recog- nized by the Internal Revenue Service in 1952, but the concept of employee stock ownership plans has been a part of our law since 1921 in the form of stock bonus plans. Stock bonus plans, like ESOPs, are tax-exempt trusts that are designed to enable employees to own part or all of the company they work for without investing their own funds. The distinguishing feature of an ESOP is that an ESOP, unlike a stock bonus plan, may engage in leveraged purchases of company stock. That is, an ESOP not only may acquire stock on a year-by-year basis, but also may borrow funds (usually personally guaranteed by the owner) in order to purchase a block of stock. Historically, ESOPs have tended to be used by C corporations, though S corporations also qualify and now use them frequently as well. ESOPs cannot be used by limited liability companies.
An ESOP is a kind of employee benefi t plan, similar in some ways to a profi t-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares.
Alternatively, the ESOP can borrow money to buy new or existing shares of its stock, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax deductible, within certain limits, a major plus for this strategy.
According to the National Center for Employee Ownership (NCEO), there are approximately 11,000 employee stock ownership plans (ESOPs) and stock bonus plans covering more than 10 million employees in the United States. The NCEO estimates that an additional 10 million employees participate in plans that provide stock options or other forms of individual equity to most or all employees. Up to fi ve million employees participate in 401(k) plans that are
primarily invested in employer stock. As many as 11 million employees buy shares in their employer through employee stock purchase plans. Eliminating overlap, the NCEO estimates that approximately 28 million employees partici- pate in a formal employee ownership plan in one form or another.
Those are impressive numbers, but how do they apply to independent fi nancial services professionals and advisors? For practical purposes, it depends on the size of the business or fi rm. Here are some general guidelines to consider before an ESOP even starts to enter into the picture:
■ Employee payroll is $1 million per year or more.
■ Succession management is in place and strong (an ESOP does not create a succession plan).
■ Business value is $5 million or more.
■ Staffi ng consists of at least 15 employees.
■ Must be a C corporation, S corporation, or willing to switch to one of these two entity structures.
Accepting these general guidelines means that ESOPs are probably a consideration for less than 1 percent of today’s independent fi nancial ser- vices and advisory practices; adding another federal regulator to your over- sight list and being willing to pay the cost of setting up and maintaining an ESOP cuts that number by more than half. In sum, we don’t see many ESOPs in the practices, businesses, and fi rms we work with. But we have many clients who do surpass the levels just listed, so this strategy bears fur- ther exploration and explanation.
Why would an independent advisor or fi nancial services professional take the ESOP route? Look at some of the major research on ESOPs for a quick answer. Various studies by the NCEO, the U.S. General Account- ability Offi ce, Rutgers University, the University of Washington, and many others come to a consistent conclusion: Companies with an ESOP grow faster and more sustainably than businesses without a formal employee ownership plan. The culture of ownership is a key to increased productivity in an ESOP company. One specifi c example found that what would have been a 10 percent annual growth rate became a 15 percent growth rate in an ESOP company in which there existed a strong ownership culture (i.e., one in which a broad base of employees felt empowered as co-owners).
ESOPs also enjoy a number of tax and fi nancial advantages not avail- able through other types of plans or strategies:
■ If the ESOP acquires 30 percent or more of the outstanding stock of a privately held company, any capital gains tax on the transaction is deferred indefi nitely, provided that the seller reinvests the proceeds in
“qualifi ed replacement property” within 12 months of the date of sale.
■ Unlike a sale or merger, the ESOP enables the seller to sell any portion of his or her stock. A sale or merger usually requires the seller to transfer 100 percent of the control.
■ The ESOP enables the company to repay principal with tax-deductible dollars.
■ Dividends paid on stock held by an ESOP are fully tax deductible, pro- vided that such dividends either are passed through to ESOP participants or are used to make principal or interest payments on an ESOP loan.
■ An ESOP enables an owner to keep control until he or she is ready to fully retire. When the owner does retire, the ESOP enables the owner to pass control to his or her key employees.
■ An ESOP can be used to enable a company to make acquisitions of other companies with tax-deductible dollars. In addition, by using an ESOP, the sellers can receive their proceeds tax-free under IRC Section 1042.
ESOPs are most commonly used to provide a market for the shares of a departing owner of a successful, privately held business and, in the process, to motivate and reward employees and to take advantage of incentives to borrow money for acquiring new assets with pretax dollars. In almost every case, ESOPs constitute a contribution to the employees, not an employee purchase, and therein lies the issue with using an ESOP to create a succession plan. Employees become the “benefi cial owners” of the stock, but not the legal owners.
Most fi rst-generation, independently owned fi nancial services or advi- sory practices survive using the “strong man” or, more politically correct, the
“strong person” approach. One owner, the founder, typically makes every- thing happen from production to marketing to sales to servicing, at least for much of the fi rst generation of ownership. As the staff grows and takes on some of those key roles, one thing never changes in most practice models:
The founder continues to power the engine of revenue production. Shifting that responsibility and power to the next generation is not something that can be accomplished by an ESOP. Production, the ability to make money for your business, is a skill, and it has to be learned and earned. In this industry, in our experience, ownership follows this process; it does not lead it.
And one more important consideration: According to the NCEO, an ESOP often costs $50,000 or more to set up and run in the fi rst year, and, for most companies “with under a few hundred people, $15,000 to $30,000 annually” to support. Annual valuations are required and the typical cost is around $7,500; sometimes more than one valuation is needed per year, depending on when the actual stock transactions occur. The ESOP plan itself bears a separate cost (usually starting at around $25,000, with fi ve-year updates required), and the transaction documents add yet another layer of cost.
Plans may also incur costs for administrators, trustees, and liability insurance,
among other things. By comparison, the cost of setting up and maintain- ing a Lifestyle Succession Plan (explained in the next section) is about one-tenth of these costs, with similar (perhaps superior) benefi ts.
For all these reasons, we don’t see many ESOPs in use by independent fi nancial services professionals, at least at valuation levels of $25 million or less. The sustainable growth benefi ts enabled by an ESOP are real, but can be accomplished with other strategies that encourage and reward internal, next-generation ownership through direct investment in the business where the next generation of advisors work and produce—perhaps not on as great a tax-advantaged basis, but with other fi nancing and growth advantages.
ESOPs support the building of enduring and stable businesses, but they do not directly address or resolve the issue of succession planning.