ABOUT ESOPs

The term "ESOP" is an acronym that stands for Employee Stock Ownership Plan.  An ESOP is a qualified retirement plan designed to invest primarily in employer securities.  As a qualified retirement plan, many ERISA plan requirements apply to ESOPS, including the following:

• The plan must be reduced to writing and have a domestic trust.
• The plan must meet non-discriminatory coverage rules of the Internal Revenue code.
• The plan must meet one of several alternative vesting schedules reflected in the Internal Revenue Code.
• Distributions must generally commence no later than 60 days after the plan year in which a participant retires or reaches normal retirement age, whichever is later, and in any event must start by April 1st following the date that the employee attains age 70 ½.

Several features make ESOPs unique as compared to other employee benefits: first, only an ESOP is required by law to invest primarily in the securities of the sponsoring employer; and second, ESOPs are unique among qualified employee benefit plans in their ability to borrow money.  As a result, a “leveraged ESOP” can be used as a technique of corporate finance. 

Effective with 1996 changes to the Internal Revenue Code, an ESOP can hold shares in an S corporation; these changes also provide ESOP’s with exemption from the application of the unrelated business income tax on earnings from S corporation shares.  Accordingly, neither the S corporation nor the ESOP Trust incurs any federal income tax liability with respect to S corporation shares owned by the ESOP Trust. 

The tax benefits associated with the HGI ESOP will facilitate the achievement of Holding’s acquisition program in several ways.  Most importantly, an ESOP Trust can provide a unique market for the equity of a retiring owner, or any interested shareholder of a closely held “C” corporation.  Shareholders of “C” corporations incur no taxable gain on their sale of stock to an ESOP, provided that the plan owns at least 30% of the company immediately after the sale, and the sale’s proceeds are reinvested by the shareholder in qualified “rollover” securities within a 15 month period.  (This could prove especially attractive to shareholders of closely held companies anticipating sharp increases in capital gains tax rates).  As long as the seller continues to own these rollover securities, he or she does not have to pay capital gains taxes.  Once the seller sells the rollover securities, he or she must pay the capital gains tax. If the rollover securities become part of the owner's estate, capital gains taxes are never paid.

It is common for selling shareholders to purchase extremely high-quality rollover securities that can be used as collateral for a loan.  These securities are often floating-rate notes (FRNs) issued by blue-chip companies.  FRNs are designed so that interest payments float in tandem with interest expenses incurred by the borrower using the FRNs as collateral.  A seller will purchase FRNs with the proceeds of the sale of stock to an ESOP and borrow against the FRNs.  The amount available to borrow varies, but is typically between 85% and 95% of the face value of the FRNs.

This tax free rollover is the most tax favored way for owners of a closely held company to sell their stock, and thus encourages the owners of closely held companies to sell their stock to ESOPs.