The Leveraged ESOP Rollover

The Leveraged ESOP Rollover

By David DuWaldt

January 15, 2010

Although sales price and terms are important components of any stock sale transaction, the structure of such a transaction can have a major effect upon what the seller is left with after taxes are paid on the resulting capital gain.  In the case of a management buyout transaction, a structure worthy of consideration involves the use of a leveraged ESOP.

ESOP is an acronym for Employee Stock Ownership Plan, which is a special type of qualified employee benefit plan.  An ESOP is a defined contribution plan that can emulate either a money purchase pension plan or a profit sharing plan.  An ESOP is similar to a stock bonus plan except that, unlike a stock bonus plan, it can utilize the credit of the company, borrow funds from outside sources, and use the funds to purchase company stock from existing stockholders.  The fact that an ESOP can enter into this type of leveraged transaction is what makes it different from all other qualified employee benefit plans.  The act of borrowing funds through the credit of the company and buying company shares is considered a prohibited transaction for all other employee benefit plans under the Employee Retirement Income Security Act of 1974 (“ERISA”).

As with other employee benefit plans, the ESOP operates as a trust.  Therefore, an Employee Stock Ownership Trust (“ESOT”) is created and a designated trustee or trustees serve in a fiduciary capacity on behalf of the employee beneficiaries of the trust.  The trustee or trustees for the ESOT are appointed by the company’s board of directors.

Section 1042 of the Internal Revenue Code provides a substantial tax benefit with respect to ESOPs.  Upon sale of company stock to an ESOP, the shareholder can reinvest the proceeds in “qualifying replacement property” (i.e., most domestic securities) within twelve months after the date of sale and defer the capital gains resulting from such a sale.  This is more commonly referred to as an “ESOP Rollover” transaction.  The qualifying replacement property is generally domestic equities and bonds, including those of publicly traded companies.  However, it is important to note that qualifying replacement property does not include mutual funds, municipal bonds, or U.S. Treasury obligations.  The tax basis in the qualifying replacement property equals the price paid for such securities less the deferred gain from the sale of company stock to the ESOP.

Other specific requirements for obtaining this favorable tax treatment include the following:

  • The stock sold to the ESOP must be from a domestic C corporation.
  • At least 30 percent of the outstanding stock is sold to the ESOP.
  • The stock had to be held for at least 3 years.
  • The stock sold to the ESOP must be acquired by investment (i.e., not by distribution from the ESOP).
  • Disclosure and the tax election are made by the selling stockholder(s).

Effective January 1, 1998, ESOPs do qualify as a stockholder in an S corporation; however, there are limitations and restrictions with regard to ownership in S corporation stock.

With a leveraged ESOP, the repayment of debt is accomplished over time by the company making cash contributions to the ESOP, which, in turn, are used to pay back the debt.  Since the contributions to the ESOP are fully deductible by the company, in essence, both principal and interest on the loan are being paid back with before tax dollars.

As with any transaction involving significant tax benefits, it is important to seek competent tax counsel before pursuing a leveraged ESOP rollover strategy.  Since ESOPs have been around for a long time, there are good advisors that specialize in ESOP related transactions.

posted by David DuWaldt