Selling to an ESOP

8th ed. (2005); 236 pp. (6" x 9"), softcover. $25 for NCEO members; $35 for nonmembers.

A comprehensive guide for owners, managers, and advisors of closely held companies considering setting up an ESOP in order to buy part or all of the stock of the owner(s). The first half of the book describes how ESOPs work and discusses basic considerations for selling to an ESOP, ranging from valuation to financing. The second half of the book focuses on the tax-deferred Section 1042 "rollover" that allows selling shareholder(s) in closely held companies to indefinitely defer capital gains taxation on the proceeds from the sale to an ESOP. The eighth edition has been revised to tighten up the organization of the book and to reflect recent changes in law and practice.

For more details on contribution limits, accounting, due diligence, ESOPs in mergers and acquisitions, etc., see Leveraged ESOPs and Employee Buyouts as well. For more information on valuation, see ESOP Valuation.

Introduction
An Introduction to ESOPs
Lending Considerations for ESOPs
Understanding ESOP Valuation
ESOP Feasibility
How Small Is Too Small for an ESOP?
A Practical Approach to ESOP Contribution and Allocation Limits
S Corporations and ESOPs
Studies of Closely Held ESOP Companies
An Introduction to Section 1042
Seller-Financed ESOPs and Leveraged QRP Transactions
Are ESOP Floating Rate Notes Right for You?
"Tacking" On to the Section 1042 Seller’s Holding Period
Qualifying Sellers for Section 1042 Rollover Treatment When They Sell to Another Company’s ESOP
The Prohibited Allocation Rule Under Section 1042
Reinvesting the Section 1042 Rollover
Case Studies of Section 1042 Rollover Reinvestments

Excerpts

From Chapter 1, "An Introduction to ESOPs"

To establish 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, 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, generally up to 25% of covered pay.

ESOPs are governed by detailed rules designed to ensure employee participants are treated fairly. Shares in the ESOP trust must be allocated to individual employee accounts. Normally, all full-time employees over 21 with at least 1,000 hours of service in a year participate in the plan, although a company can exclude employees covered by a collective bargaining agreement (provided it bargains in good faith about whether these employees will be included). In some cases, however, ESOPs can include only employees in a certain line of business of the company, provided the effect is not to discriminate in favor of higher-paid people (such as making the managers a separate division). ESOPs can also base participation on matches of employee contributions to a savings plan such as a 401(k) plan, provided certain complex rules assuring equitable participation by lower-paid employees are met.

From Chapter 4, "ESOP Feasibility"

If however, a shareholder holds stock that is ineligible for “tax-free” rollover treatment, it may be possible to have a tax-free recapitalization that converts the existing ineligible stock (nonvoting common, straight preferred, etc.) into eligible stock. The details that determine whether such a recapitalization can be accomplished on a tax-free basis go beyond the scope of this chapter. However, shareholder approval of such recapitalization is normally required. If such a tax-free recapitalization can be accomplished, the holding period of the old security prior to conversion is “tacked on” and can be used to satisfy the three-year holding period required for tax-free rollover treatment. It is not necessary to start the “holding period” clock over again after a conversion.

From Chapter 6, "A Practical Approach to ESOP Contribution and Allocation Limits"

A company may choose to deliberately reduce eligible payroll when designing an ESOP. For example, the ESOP may exclude compensation over an amount that is less than $205,000 (or $164,000—the effective cap on compensation as a result of the annual addition dollar limit of $41,000, which is 25% of $164,000, not $205,000) as a way to spread the ESOP benefit to lower-paid employees (because allocations to ESOP participants’ accounts are based on each participant’s eligible payroll or something more equitable, lowering the amount of eligible payroll that is counted makes everyone’s ESOP benefits more equal). Alternatively, the company may count only regular wages and not commissions or bonuses (similarly, this would prevent higher wage earners from receiving proportionately higher ESOP benefits). A company also may decide to broaden participation in an ESOP by not requiring a minimum number of hours of service or employment on the last day of the plan year in order to receive an allocation. This will generally increase the amount of such an employer’s deductible contribution limits under Section 404 of the Code.

From Chapter 14, "The Prohibited Allocation Rule Under Section 1042"

The prohibited allocation rule applies only when an ESOP has purchased employer securities from a shareholder who has satisfied the requirements for a Section 1042 rollover. Consequently, when there is only one selling shareholder, the shareholder and any related parties can fully participate in the ESOP if the shareholder does not make the Section 1042 rollover. However, if there are multiple selling shareholders, the situation can become more complicated if even one of them makes the Section 1042 rollover. The more-than-25% shareholder rule (discussed below) can prevent even a shareholder who does not make the election from receiving ESOP allocations attributable to the Section 1042 shares.

What happens if a selling shareholder attempts to make the Section 1042 rollover, but fails, for example, where the 30% ESOP ownership requirement of Section 1042 is not met or where the shareholder fails to make a timely 1042 election? The prohibited allocation rule is applicable by its terms only to assets “acquired by the plan . . . in a sale to which section 1042 applies.”3 If Section 1042 does not apply because of a failure to meet its requirements, the prohibited allocation rule will not apply either. If the Section 1042 rollover is partly effective and partly ineffective, the prohibited allocation rule will still apply, because Section 1042 would still be partly applicable.

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