Current issues and opportunities for ESOP companies
Notes from this year’s ESOP conference season
INSIGHT ARTICLE |
More companies are interested in ESOPs, and an increasing number of companies are using them. But there remains a divide. Companies and advisors with little exposure to or knowledge of ESOPs still seem to fear them. Following are some key ESOP trends.
100 percent ESOP transactions are more common
More companies are using or considering 100 percent ESOP transactions in today’s market than a few years ago. Along with these 100 percent transactions come some interesting transaction details:
- Private equity investors are now showing interest in ESOP companies. Companies used to think of an outside private equity buyer and ESOP as an either-or proposition, but that’s no longer the case. Because of the increasing prevalence of 100 percent deals, sellers need sources of capital beyond unsubordinated bank debt. Private equity investment can fill that gap. Private equity investors usually want to act as partners in operating the company, though, so transactions with private equity firms get complex.
- Companies pursuing 100 percent transactions tend to use alternative financing structures, such as warrants or other tools, to provide upside to parties outside the ESOP. These tools can be valuable and vital to the transaction, but ESOP companies need to fully understand these options before implementing them and consider future implications from the beginning.
- Partnerships and LLCs are now also pursuing ESOPs. These entities need to either convert to or elect corporate status, which raises complex tax rules that must be considered carefully before the transaction.
- These are typically highly leveraged transactions. As such, the plan sponsor must make sure that they continue to have access to the financing lines they need to support day-to-day operations.
- Even with an increased number of transactions, there is neither clear tax or regulatory guidance, nor consensus within the ESOP community, regarding some common transaction details. For example, if a company redeems shares and then sells them to an ESOP, should the share price be the same for both transactions? What is an appropriate term for an inside loan? Do step transaction rules apply when a seller takes a note or cash from an ESOP and then either swaps the note or loans the cash back to the company? Can a partnership convert without tax to a C corporation in anticipation of an ESOP transaction closing shortly after the incorporation?
Companies and advisors with little exposure to or knowledge of ESOPs may avoid these transactions out of fear of the complexities or rush in without properly evaluating the risks. While ESOP transactions can be very complex, they may also provide great outcomes for selling shareholders and sponsoring companies and their employees when properly structured.
Don’t view an ESOP in a vacuum
ESOP companies must remember to balance employee benefits with corporate strategy and look at the ESOP as part of the entire benefits package. To achieve the best outcome, companies have to actively communicate the value of the ESOP to their employees. When weighing whether to proceed with an ESOP, companies should also consider the volume of academic research that supports the proposition that, when employees are actively engaged in the success of the business, the business performs better, is more likely to survive economic downturns, and experiences less employee turnover.
Also, as the economy continues to go global, there needs to be an understanding of how an ESOP affects non-US employees. The IRS recently ruled that foreign employees can be eligible ESOP participants in some cases, but many companies still choose cash bonuses or synthetic equity tools for foreign employees, often due to legal and tax ramifications in other countries.
Finally, companies are increasingly focusing on managing repurchase obligations as ESOPs mature to ensure adequate cash flow (which could mean a need to recapitalize), to move equity from the accounts of former employees to those of active employees, and to manage the impact on aggregate employee benefit levels over time.
Regulatory issues are a key ESOP concern
The great benefits an ESOP can provide can be erased if the rules are not appropriately followed. There are a few issues of note in the current regulatory environment that are relevant to ESOPs.
First, the Department of Labor remains very concerned with valuations of non-traded employer securities in ESOP transactions in particular. The combination of heightened DOL scrutiny and larger ESOP transactions is driving a trend toward the use of more independent board members, outside trustees and competent advisors during ESOP valuations and feasibility analyses. For example, it is vital that the ESOP trustee, not the company, engage the appraiser to support that valuations are performed at arm’s length and are appropriately documented. ESOP transactions have not historically used the same due diligence process that sales to outsiders do, but these transactions are edging closer to this process as all parties look to confirm that the transaction was carefully considered and employees’ retirement benefits are protected.
Second, the IRS is changing the determination letter process to remove letters for individually designed plans, except at inception and termination and in the event of certain amendments, as periodically identified by the IRS. Historically, ESOPs have been individually designed plans, but the IRS recently expanded their pre-approved document program to cover ESOPs. Thus, in the future, companies may be able to adopt an already-approved ESOP plan document rather than getting an individually designed plan document. It remains to be seen how many providers will offer pre-approved ESOP documents, though, as ESOPs are not like 401(k) plans with fairly consistent and uniform options. ESOPs tend to be individually designed to meet specific employee benefit goals. However, ESOP sponsors whose plans fit the terms of the pre-approved documents may consider switching since individually designed documents may offer less comfort regarding the plan’s qualified status in the future.
On a related note, the IRS has hinted it may extend the remedial amendment period for certain required plan amendments to Dec. 31, 2017. Without this extension, plan sponsors will need to make all required amendments by the due date of the tax return, including extensions. That could be as early as March 2017.
There is continued uncertainty surrounding the allocation of S corporation distributions on unallocated ESOP shares or shares held as collateral. The confusion stems from seemingly inconsistent IRS positions over time. S corporations making distributions to leveraged ESOPs should carefully consider these allocations inside the plan and weigh the options for allocating them to participant accounts. Allocating based on account balance offers increased benefits to employees with longer service at the company, while allocating based on compensation provides a benefit to new hires who may have few, if any, shares in their accounts.
Finally, the IRS is approving the correction of some 409(p) errors for relief under the Voluntary Closing Agreement Program. Because a 409(p) violation can be catastrophic to an S corporation and the ESOP, this relief is welcome news to taxpayers.
In summary, ESOPs are heavily regulated. Keeping abreast of regulatory changes and trends in enforcement focus is vital for all ESOP companies.
Despite the technical intricacies, the ESOP community remains unique and energized with respect to the benefits employee ownership can offer when it is the right fit and when knowledgeable advisors are involved.