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Monday, April 29, 2024
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Case Studies |
Another Tale from ESOP's Fables, Part I
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Case:
Eric and Stephanie Hawkins, both age 50, have decided that they are tired of the fast-paced lifestyle of running a small business. They started their Seattle printing business, Speedy Printing, Inc., just after they were married 20 years ago. It has now blossomed into a multiple-location, 50-employee company netting over $350,000 annually. The printing business is currently structured as a C corporation and Eric and Stephanie own 100% of the stock. Their CPA stated that their stock is probably worth well over $5,000,000.
They have been very fortunate to hire a good mix of employees who have been faithful to them and to the company. On the other hand, Eric and Stephanie have provided their employees with nice benefits, including health care, childcare, fitness facilities, generous vacation packages and bonus plans. As a result, many of the employees have now been with the company over 15 years. It is known throughout the Seattle printing world as the choice place to work, and when positions come open, multiple job applications are always received.
Eric and Stephanie have had many discussions about how to phase out of the business in order to have more time for themselves and their two children, ages 12 and 15. They have always dreamed of owning a bed and breakfast on San Juan Island. In fact, a few years back they purchased a five-acre parcel of farmland with a house, hoping some day to begin their new career. They feel that there is no better time than now to begin the transition from company president and CEO to the owners of a bed and breakfast located on San Juan Island.
In order to reward their employees, especially upper and middle management, Eric and Stephanie were advised by their attorney to establish an employee stock ownership plan (ESOP). The ESOP is designed to provide beneficial equity ownership in the corporation by its employees. Each employee participates in the ESOP in substantially the same proportion as his or her relative earnings, and benefits are provided to them in the event of death, disability or retirement. The ESOP is a plan qualified by the Internal Revenue Service in which the company makes cash contributions that are deductible from its pre-tax earnings. The money is then reinvested in company securities which are then held in trust for the benefit of the employees. The shares purchased by the ESOP may be newly issued shares purchased from the company, or existing shares held by individuals desiring to divest themselves of such shares.
That's what Eric and Stephanie liked about the ESOP - it is a mechanism by which employees can become beneficial owners of stock in their company and the Hawkinses can sell their stock to the ESOP, thus divesting themselves of ownership in the company. In other words, the ESOP becomes a ready and willing buyer for some or all of their closely held stock. However, in order to purchase the stock, the ESOP must have cash. The plan can acquire cash through deductible contributions by the company, or by borrowing the funds from a bank. This was another nice feature that appealed to Eric and Stephanie. Unlike other qualified plans in which borrowing would be considered a prohibited transaction, a special exemption is provided for an ESOP. An attractive interest rate is available for ESOP borrowing because, under Sec. 133 of the Internal Revenue Code, 50% of the interest income on a loan transaction to an ESOP is not taxed to the lending institution. The result of this is that the lender will typically lend at 80% to 85% of prime. The company is then able to make fully deductible principal and interest payments to the ESOP, which repays the loan.
The ESOP is a plus for the current employees for a number of reasons. Through their ESOP accounts, they become owners of the company and thus have an opportunity to share in its growth. The employees have a meaningful retirement fund and a new sense of team spirit as stock owners, and are confident in the continuation and perpetuation of the company should Eric and Stephanie decide to sell it in the future.
Question:
Having just set up the ESOP a couple of years ago, Eric and Stephanie have sold over $500,000 of their stock to the ESOP. They have used most of these funds, net of capital gains taxes, to retire a good portion of the debt they incurred to purchase the property on San Juan. They would like to sell much more of the stock to the ESOP, but since their basis in the stock is almost nil, they are concerned about the capital gains taxes. They certainly did not like the idea of paying $100,000 in tax on the previous sales! Also, Eric and Stephanie are concerned about the welfare of their children should something happen to them and would like to make sure the children will be well cared for in the event of an unexpected tragedy.
Solution:
As with most fables, this tale continues on for another chapter. The solution will be contained in Part II.
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