Let's Get Wealthy with ESOPs!

(Specific Use Cases)

As a reminder from the last issue, an Employee Stock Ownership Plan, (ESOP) is a non-discriminatory, tax-qualified employee benefit/retirement plan, born out of the 1974 Employee Retirement Income Security Act, affectionately referred to as ERISA. It’s a trust fund that owns shares in the company, for the benefit of the employees. The trust is set up and funded by the company. It can be paired with a 401K plan or stand alone. It’s the most powerful way for employees to enjoy the fruits of their labors through company ownership and it provides a plethora of advantages for the original company owners. It’s like a friggin’ miracle! As a CPA, I’ve known about ESOPs for a while, but this deep dive blew my socks off with the multitude of ways it can be utilized, and how it can allow both owners and employees to create a new level of wealth.

Moving forward with an ESOP is pretty straightforward, as you'll see here.

1. Prepare a feasibility study. This will include an analysis of items such as:

• Is there adequate payroll?

• Is there adequate cash flow?

• What will the repurchase obligations entail?

2. Complete a business valuation. The valuation expert should be hired by the trustee and should not have any conflict of interest. Valuations must be completed on an annual basis.

3. Obtain funding for the ESOP. Funding sources could include borrowing money from:

• Traditional banks

• Private parties

• Existing benefit plans

• Bond market

Larry lays out the funding plan as follows, “Where's the money come from, right? The employees don't have any money. And if I'm a shareholder, yeah, I'd rather sell to my employees. But if they have no money, where are they going to get the money to buy my company? We leverage a company's balance sheet. And the most important thing is, if they're big enough companies, [we do it] on a completely non personal recourse basis. Lenders are lending money to the company, collateralized only by the cash flow and the assets of that business. So we've got a network of banks and non-bank lenders all across the country that are actively seeking to invest into employee owned companies. And that bank will lend the money to the company, the company lends that money to the ESOP. And the ESOP gives that shareholder the cash, [in exchange for shares of company stock] so it's a debt financed transaction. And because the company doesn't pay any taxes, we can pay down that debt very, very quickly, and then build up the equity value for the employees.”

4. Choose a trustee.

5. Hire an ESOP attorney to create the plan and trust documents. Documents will be submitted to the IRS for a determination on whether or not it meets the tax qualification requirements.

6. Select the third-party administrator, like Larry's company CSG Partners, who will:

• Maintain all record keeping for the plan.

• Maintain all record keeping for the employees.

• Perform non-discrimination testing.

• Purchase the stock.

• Communicate the benefit to employees.

Now that the ESOP is your new favorite tool on the bench, let’s look at some of the finer nuances and the masterpieces that can be created with it.

Publix Super Markets is the poster child for this program. It’s the largest employee-owned company in the United States, with 80% of Publix stock being held in their ESOP. Every employee at Publix receives company stock after 12 months of service, regardless of position or salary. Their profit margins are the highest of any company in the industry at 7-8%; higher than Wal-Mart’s which is around 3% and way higher than Kroger’s at a measly 2%. Publix has about 225,000 employees. Of that total number, stock is held by approximately 205,000 Publix workers, 91%. Barrons.com estimates that the average Publix employee has about $150K in company stock. Much of the company’s success is credited to the corporate culture built on the premise of employee ownership, translating into the highest level of customer service delivered to patrons at all 1300 Publix stores.

Though this next company cannot be named directly, Larry shared another success story. “We did an ESOP we implemented for one of our clients about five years ago. They were an insurance brokerage operation, primarily property and casualty, a nice local regional property and casualty agency. Then we sold 49% of that stock [to the ESOP], and the employees started building value. There were 40 employees, right. And within four years, five years of implementing that ESOP, they started receiving takeover offers that were so high, that they had to take, I mean, they were just really crazy offers. And so within five years, 40 employees split $70 million. Now, that is a 100% true story.” He goes on to say, “And by the way, they get that cash, that goes into their IRAs, because a lot of these employees were 35, 40 years old. They get to keep that money growing in a tax deferred account until they hit mandatory retirement age. So it's life changing for them.”

As mentioned earlier, the ESOP is a non-discriminatory plan, but that can be “enhanced” we’ll say, with a little Kaplan Kreativity. (I made that up.) Larry calls it an ESOP-MBO, or ESOP Management Buy Out. He describes it like this, “So the ESOP itself is what they call non-discriminatory, that's why everybody participates equally, based on their compensation. …You've got an employee making $150,000. You have another one making $50,000. Each year, when shares get allocated, that $150,000 employee will get three times the amount [of company stock] as the $50,000…but a lot of times…we combine a management buyout with an ESOP. …We'll try to build into the deal where key managers can have up to 20 or 30% of the company. So they'll all be participants with the ESOP, but we want to build up a little something extra for the top people, so that they're completely incentivized. So everyone's rowing in the same direction and they get a little bit extra.”

We’ve talked about the ESOP as a liquidity/exit strategy, but it is also great for an acquisition strategy. Larry shares this example, “Say the business owner is not ready to retire. They want to do a…growth by acquisition strategy. We could turn these companies into 100%, employee-owned S Corporations. …The owners can have approximately, let's say, 45% of the stock in what they call synthetic equity…which gives them [the owner] the right to buy back in at a later date, at a price that's scheduled at the time of the transaction. So now I've got a company that's entirely tax free. The owner participates in…this tax-free business. And now they can acquire all their competitors around the country. When they acquire them, the owner of that selling company, if he sells to them [to the ESOP] he doesn't have to pay capital gains taxes on it. And then that cash flow stream comes into it [the company, with] no taxes of ordinary income. The most ideal platform to start acquiring companies is an ESOP, far better than any other structure. And that's what we're trying to get these businesses to do.”

Larry shared an incredible use case for the ESOP as an estate planning tool. He says, “Many business owners…haven't done estate planning. So they built up that company, and they got all this equity value that's locked in that stock. And they gotta pay lots of taxes both on the sale and upon death. So what we do, just give you an example, we'll do a transaction where they'll sell 49% of the company to an ESOP, keep 2% for themselves. Post transaction, when the debt is on the company, [from funding the ESOP] they'll then gift to a family trust the other 49%. And now, since they're gifting a minority piece, [because] they started the company as valued here [at a relatively high value]. They put the debt on the company from the transaction, [which temporarily reduces the company value]. Now they're gifting a minority piece. …You're able to make that gift for practically zero.” As the participants in the ESOP retire, the company, owned by the next generation, buys that stock back from the retirees. As the ESOP’s ownership percentage shrinks, the business can eventually become family owned once again. Liquidity and family ownership all in one.

And we’ll end on a “high” note with Kaplan’s thoughts on how this can benefit the tax burdened cannabis industry. I’m getting the munchies as I listen to him explain, “The problem with being a cannabis retailer is that…there's a section of the tax code called 280E. If you're a cannabis retailer, you cannot deduct any of the expenses. So whatever your gross profit margin is [that’s also] your profit. That's what your taxable income is. So even though there are a lot of these retailers that are making a profit, they're not generating any positive cash flow, because they have to pay everything out in taxes. And it's killing the industry. And until there's federally approved legislation, you're not going to see this change. And so what we've been trying to promote within the cannabis industry, is if you're starting a new company, we're trying to convince business owners to create your business as 100%, employee-owned S Corporation.” He breaks this down as follows, “Now I've got 100%, employee-owned S Corporation, it's not paying any taxes. It's not subject to 280E because it doesn't pay any taxes. …So now all these employees, right, are sharing in the upside. So the problem…is that people, it's complicated. And yes, you're gonna give away some of the upside, right? …But the tax benefits are so huge, that at least you're gonna be generating cash flow and then sharing it … and then everybody does better. I think it's a great idea.” I certainly agree with Larry here!

If your brain isn’t too foggy from this “blunt” of info, then the moral of the story should be clear. Every business owner needs to explore the multi-faceted, thing-a-ma-bobby tool known as the ESOP. If done carefully, in the right situation, Employee Stock Ownership Plans can create wealth for both owners and employees. They can also provide alternative financing options, reduce and even eliminate taxes, and provide efficient estate planning.

P.S. My boyfriend says he hasn’t opened the hatchet-thingy because he needs the hatchet-thingy to get through the damn packaging!

(A special thank you to  Ronald Skelton  and his interview of Larry Kalpan;-)