The “grow or die” business ethos may have been discredited, but sometimes growth is essential to maintain market share or fend off challenges from competitors. A business growth strategy can take many forms, such as expanding capacity or a strategic acquisition, but the common element is the need for capital. A great strategy will come to nothing if the company cannot pay for it.
What is an ESOP?
An ESOP is a tax-qualified employee retirement plan (specifically, a form of “stock bonus plan”) to which a company makes discretionary contributions of its stock or cash that is used to buy the company’s stock. Alternatively, an ESOP can borrow money itself from a third party to buy existing or new stock in the company. The stock contributed or purchased is then allocated to separate accounts established for each participating employee under the ESOP. While contributions are not required to be made to an ESOP every year, the Internal Revenue Service (IRS) will require the company to make substantial and recurring contributions to the plan. For practical purposes, an ESOP loan typically requires annual employer contributions.
Tax-qualified retirement plans permit the employer to deduct contributions to the plan on a current basis, but allow the employee participants to defer recognition of income on their share of these contributions (including earnings) until actually distributed, generally after retirement or other separation from service. When an ESOP is used to fund an acquisition or capital expansion, the tax benefit of current deductibility can significantly enhance the financial viability of the transaction.
Key Objectives and Uses of an ESOP
Perhaps the most common use of an ESOP by a privately owned corporation is to purchase the stock of a deceased or retiring stockholder, but this article focuses on two quite different uses, which can be pursued simultaneously and in a synergistic fashion to enhance the likelihood of achieving both objectives:
- ESOPs in Acquisitions and Expansions. Whether the company raises the capital needed to implement a growth strategy by borrowing or equity investment, it will typically need to repay the loan or provide a return to the investors. Instead of making these payments directly with after-tax dollars (except for deductible interest payments, although there may be limits to interest deductions under the 2017 Tax Cuts and Jobs Act), the company can sell stock to the ESOP on terms that mirror the required payments on the underlying loan or equity investment. Within applicable limits, this effectively lets the company make the payments with pre-tax dollars.
- Establish an Effective Employee Retirement Program. Because an ESOP is designed to invest in the employer’s stock, growth in the value of the participants’ accounts is tied to growth in the value of the company. When properly implemented and communicated to employees, the connection between retirement benefits and the company’s value can help promote loyalty and create a self-sustaining culture of commitment to the company’s goals within the workforce.
Read more at Financial Executives International (FEI)