As your company contemplates the future, you may consider several options during the succession planning process: continued private ownership by an individual or individuals, sale to an insider, a sale to an outside investor, or sale to the company’s employees by developing an employee stock ownership plan (“ESOP”).

The purpose of this document is to explain some of the options of transferring stock from current owners to employees through an ESOP. The various methods of structuring a transfer of stock discussed here are:

• Leveraged Sale; 
• Seller-Financed Sale; and 
• Annual Installment Sale/ESOP Purchase.

The examples contained herein assume (1) an ESOP will be established during the current year; (2) that your Company has a 401(k) plan which will remain in place; and (3) the ESOP trustee will be a group of employees approved by the Company’s Board of Directors.

Keep in mind as you review these options that they do not have to be exclusive of each other; you can combine one or more of the ESOP options into your ownership transition structure.

LEVERAGED SALE:

This method of ESOP stock acquisition requires the Company to borrow funds from a bank to facilitate the ESOP’s stock acquisition transaction (assuming the Company does not have the necessary cash reserves available to self fund the transaction). The Company, in turn, would lend the funds to the newly-formed ESOP. The ESOP would use 100% of the funds it borrowed from the Company to purchase a block of stock from the Shareholders. A Leveraged Sale requires the block of stock purchased by the ESOP to be valued as of the single date on which it is purchased.

Allocation of Shares in a Leveraged ESOP: In the case of a Leveraged ESOP, the shares are considered unallocated and held in a suspense account until the Trustee makes the loan payments to the Company. In this example, the loan is being repaid over a 10-year period, so 1/10th of the total shares are “allocated” to participant accounts each year.

SELLER FINANCED SALE

This method of ESOP stock acquisition requires the Selling Shareholders to act as the ESOP’s financier, instead of a bank (or using the Company’s cash reserves). Under this scenario, each Selling Shareholder would receive an IOU (together the “ESOP Notes”) from the ESOP in exchange for stock. The Company would typically guarantee the ESOP’s payment of the ESOP Notes, and the Selling Shareholders would typically be afforded instalment sales treatment for the payments due under the ESOP Notes.

This income tax treatment provides the Selling Shareholders with the ability to recognize capital gains as payments are received each year during the term of the ESOP Notes, instead of realizing the total amount of capital gains received from the ESOP as of the date of the stock sale to the ESOP.

Seller financing can be, and often is, combined with a bank leveraging and/or annual instalment sale to provide Selling Shareholders with a cash down payment at the closing of a Seller Financed ESOP stock purchase. A Seller Financed Sale requires the block of stock purchased by the ESOP to be valued as of the single date it is purchased.

Allocations of Shares in a Seller Financed ESOP: In the case of a Seller Financed ESOP, the allocation of shares to eligible employee accounts takes place in the same manner as in a Leveraged ESOP

ANNUAL INSTALLMENT SALE / ESOP PURCHASE

This method of ESOP stock acquisition finances the purchase of stock annually based upon the cash the ESOP has available to purchase stock each year. The Company’s annual cash contribution(s) to the ESOP could be the ESOP’s annual source of cash flow for the stock acquisitions. To the extent available, S Corp income distribution amounts also may be used to fund stock purchases. This method of stock acquisition by an ESOP is less certain than the methods discussed above (and can be combined with either method, cash flow permitting) because (I) the Trustees must determine each year how much stock it can afford to purchase from the prospective Selling Shareholders; (ii) the stock price must be fixed each year as of the date of each ESOP stock purchase; and (iii) the Selling Shareholders can become obligated under a written agreement to offer the Trustee the opportunity to purchase a set number of shares of stock or percentage of their stock holdings on or about a specific date, but the Trustee cannot be obligated to purchase the stock in advance. This method provides the Selling Shareholders with a potential fluctuation (+/-) in stock sale pricing because of the Trustee’s obligations to pay the Selling Shareholders fair market value of the stock as of the date of each ESOP purchase. The valuation of Selling Shareholders’ stock offered for sale to the ESOP under this method is a key element of planning because the ESOP may be acquiring a controlling interest in the Company over time and the Selling Shareholders seek to be compensated for their stock at a controlling interest value at the onset of their sale of stock to the ESOP.

Allocation of Shares in an Annual Installment Sale ESOP: In the case of an Annual Installment Sale ESOP, the ESOP purchases the shares as cash becomes available. Therefore, the number of shares purchased each year may vary. The Selling Shareholders continue to own the shares until they are purchased by the ESOP. This arrangement is more flexible than a traditional Leveraged or Seller Financed arrangement, but such flexibility raises the ESOP’s annual administrative costs, because each annual installment sale to the ESOP will require (1) the Trustee to receive an opinion from its financial advisor that the trans- action meets certain ERISA standards, and (2) the preparation of separate legal documentation coincident with each of the ESOP’s actual stock purchases.