ESOPs and Ag Businesses – Part One

What Is An ESOP?

In existence since the 1970s, an employee stock ownership plan (ESOP) is a type of qualified retirement plan that is designed to provide employees with ownership in the company by investing (primarily) in shares of stock of the employer-company.  According to data from the National Center for Employee Ownership, there are about 7,000 ESOPs in the United States covering approximately 14 million employees.    

Does an ESOP work for employees of a farming/ranching operation or an agribusiness?  In part one of a two-part series, today’s post lays out the basics of an ESOP – how it’s established and the potential benefits.   In part two next week I will examine potential problem areas as well as how the new tax law (as of the beginning of 2018) impacts the use of an ESOP.

ESOPs in agriculture – it’s the topic of today’s blog post. 

General Structure

An ESOP involves employee ownership of the business.  There are several ways that an employee can obtain ownership in the business.  One is to buy stock in the company.  Other ways involve an employee being gifted stock, receiving stock as a bonus or obtaining it via a profit-sharing plan.  But, the most common way for an employee to obtain ownership in the business is by use of an ESOP. 

In the typical ESOP transaction, the company establishes the plan by means of a trust fund – an “employee benefit trust” (hopefully with competent tax and legal counsel) and appoints an ESOP trustee.  The trustee then negotiates with a selling shareholder to establish the terms of the sale of the shareholder’s stock to the ESOP.  The company borrows the necessary funds from a third-party lender on the ESOP’s behalf and loans the funds to the ESOP which uses the funds to buy the stock from the selling shareholder with the seller receiving cash and taking a note for the balance.  The company will make annual (tax-deductible) contributions of cash to the ESOP which the ESOP uses to repay the inside loan.  The company uses the payment received from the ESOP to make payments on the third-party loan. 

An alternative approach is for the company to have the trust borrow money to buy stock with the company making contributions to the plan so that the loan can be paid back.  Unlike other retirement plans, an ESOP can borrow money to buy stock.  Consequently, an ESOP can buy large percentages of the company in a single transaction and repay the loan over time using company contributions.      The trustee is appointed by the company’s board of directors to manage the trust and can be an officer or other corporate insider.  Alternatively, the trustee can be an independent person that is not connected to the corporation as an officer or otherwise.  It is advisable that an external trustee be used to negotiate the terms and execute the transaction involving the purchase of shares of stock from a selling shareholder.   The trustee has the right to vote the shares acting in a fiduciary capacity.  However, the ESOP may require that certain major corporate transactions (i.e., mergers, reorganizations, and significant asset sales) involve the participation of ESOP participants in terms of instructing the trustee with respect to voting the stock shares that are allocated to their accounts.  I.R.C. §409(e)(3).  ESOP participants do not actually own the shares, the trust does.  Thus, an ESOP participant has only the right to see the share price and number of shares allocated to their account on an annual basis.  They have no right to see any internal financial statements of the company. 

The ESOP shares are part of the employees’ remuneration.  The shares are held in the ESOP trust until an employee either retires or otherwise parts from the company.  The trust is funded by employer contributions of cash (to buy company stock) or the contributions of company shares directly.

Retirement Plan Characteristics

An ESOP is a qualified retirement plan that is regulated by I.R.C. §4975(e)(7) as a defined contribution plan.  As such, ESOPs are regulated by ERISA which sets minimum standards for investment plans in private industry.  Only corporations can sponsor an ESOP, but it is possible to have non-corporate entities participate in an ESOP.  An ESOP must include all full-time employees over age 21 in the plan and must base stock allocations on relative pay up to $265,000 (2016 level) or use some type of level formula.  ESOPs are provided enhanced contribution limits, which may include the amount applied to the repayment of the principal of a loan incurred for the purposes of acquiring employer securities.  Employers are allowed to deduct up to an additional 25 percent of the compensation paid or accrued during the year to the employees in the plan as long as the contributions are used to repay principal payments on an ESOP loan. I.R.C. §404(a)(9)(A). 

In addition, an employer with an ESOP may deduct up to another 25 percent of compensation paid or accrued to another defined benefit contribution plan under the general rule of I.R.C. §404(a)(3).

 In addition, contributions made to the ESOP applied to the repayment of interest on a loan incurred for the purpose of acquiring qualifying employer securities are also deductible, even though in excess of the 25 percent limit. I.R.C. §404(a)(9)(B).  But, these two provisions, do not apply to an S corporation. I.R.C. §404(a)(9)(C). As a qualified retirement plan, an ESOP must satisfy I.R.C. §401(a) to maintain its tax-exempt status.  While an ESOP is not subject to the normal ERISA rules on investment diversification, the fiduciary has a duty to ensure that the plan’s investments are prudent. In addition to basic fiduciary duties designed to address the concern of an ESOP concentrating retirement assets in company stock, it is not uncommon for a company with an ESOP to also have a secondary retirement plan for employees.

What Happens Upon Retirement or Cessation of Employment?

When one the employee retires or otherwise parts from the company, the company either buys the shares back and redistributes them or voids the shares.  An ESOP participant is entitled to a distribution of their account upon retirement or other termination of employment, but there can be some contingencies that might apply to delay the distribution beyond the normal distribution time of no later than the end of the plan year.  For plan participants that terminate employment before normal retirement age, distributions must start within six years after the plan year when employment ended, and the company can pay out the distributions in installments over five years, with interest.  If employment ceased due to death, disability or retirement, the distribution must start during the plan year after the plan year in which the termination event occurred, unless elected otherwise.  If the ESOP borrowed money to purchase employer securities, and is still repaying the loan, distributions to terminating employees are delayed until the plan year after the plan year in which the loan is repaid.  In addition, no guarantee is made that the ESOP will contain funds at the time distributions are required to begin to make the expected distributions.

What Are The Benefits of an ESOP?

For C corporations with ESOPS, the selling shareholder avoids the “double tax” inherent in asset sales because the sale is a stock sale.  As such, gain can be potentially deferred on the sale of the stock to the ESOP. To achieve successful deferral, the technical requirements of I.R.C. §1042 must be satisfied and the ESOP, after the sale, must own 30 percent or more of the outstanding stock of the company and the seller must reinvest the sale proceeds into qualified replacement property (essentially, other securities) during the period beginning three months before the sale and ending 12 months after the sale.  If the replacement property is held until the shareholder’s death, the gain on the sale of the stock to the ESOP may permanently avoid tax. 

Corporate contributions to the ESOP are deductible if the contributions are used to buy the shares of a selling shareholder.  As a result, an ESOP can be a less costly means of acquiring a selling shareholder’s stock than would be a redemption of that stock.  Also, the ESOP does not pay tax on its share of the corporate earnings if the corporation is an S corporation. Thus, an S corporation ESOP is not subject to federal income tax, but the S corporation employees will pay tax on any distributions they receive that carry out the resulting gains in their stock value.

From a business succession/transition standpoint, an ESOP does provide a market for closely-held corporate stock that would otherwise have to be sold at a discount to reflect lack-of marketability of the stock, although the lack of marketability must be considered in valuing the stock.  Indeed, one of the requirements that an ESOP must satisfy is that it must allow the participants to buy back their shares when they leave the company (a “repurchase obligation”).     

Compared to a traditional 401(k) retirement plan, ESOP company contribution rates tend to be higher, and ESOPS tend to be less volatile and have better rates of return.   

Conclusion

In part two next week, I will look at the potential drawbacks of an ESOP and why the U.S. Department of Labor (DOL) gets concerned about them.  That discussion will include a recent DOL ESOP investigation involving a major ag operation. It will also involve a look at how the Tax Cuts and Jobs Act impacts ESOPs.