22 ESOP Misconceptions and Myths Part I

by admin on August 23, 2012

ESOPs were initially approved by federal government law during 1974. From that day, there have been over 25 individual bits of rules which have additionally described what an ESOP is and how much of an ESOP is allowed to do. In spite of this fact, there are more myths regarding ESOPs than regarding any of the other related fiscal tools which exist in the market. The following explains a few of the more widespread misconceptions and myths about ESOPs. Hopefully, the descriptions provided below will assist to dismiss most of the myths which presently exist about these matters.

Myth # 1: ESOPs can only be used by typical C corporations Incorrect. Over one half of all new ESOPs are set up by S corporations. Initially, ESOPs could only be used by typical C corporations. But, as a consequence of law during 1996, ESOPs can now also be used by S corporations. The only important difference between S corporation ESOPs as well as C corporation ESOPs is the fact that, in the situation of S corporations, investors don’t have the additional tax benefit of selling share to the ESOP capital profits tax-delayed. But, S corporation ESOPs provide increased possibilities for tax savings than are offered to C corporations. This originates from the truth that the ESOP is a tax-exempt organization. Therefore, to the level that share of an S corporation is managed by an ESOP, a part of the corporation’s income will be tax-exempt. For instance, if twenty five percent of the share of an S corporation is managed by the ESOP, twenty five percent of the incomes of the organization will be due to the ESOP and will be exempt from taxes. In case the ESOP manages 100% of the share of an S corporation, the whole incomes of the organization will be virtually tax-exempt.

Myth #2: The ESOP is mainly a worker benefit program Usually not. The reverse is valid. The ESOP is mainly a tool of company finance which is used as an option to a sale or merger as a method of generating liquidity as well as investment diversity for proprietors of privately-held companies. An ESOP utilizes the tax benefits provided to competent worker benefit programs in order to increase the tax savings to the vendors, to the organization and to the workers, however the main goal in many cases is to generate an in-house market for the present investors instead of to generate an additional worker benefit.

Myth # 3: An ESOP purchase, like many other buyouts, mandates that the proprietors sell 100% of their share Incorrect. In fact, eighty percent or more of all ESOP deals are organized like partial buyouts instead of as complete buyouts, and several ESOPs wind up having under fifty percent of the company’s remaining share.

Myth # 4: An ESOP acquisition mandates that the proprietors sell at least thirty percent of all the remaining share to the ESOP Incorrect. Proprietors might sell any amount (one percent to 100%) to the ESOP originally or during many phases as time passes, and there’s no need that the ESOP should manage any minimum quantity of organization share. But, during the case of a C corporation, there’s a special tax savings provision which allows the vendors to delay indefinitely the capital gains tax on any of the share sold to an ESOP, given that the ESOP buys at least thirty percent of all the remaining share, and given that the vendors reinvest a similar sum in a Qualified Replacement Property. But, this alternative pertains to investors of C corporations. In all other situations, the vendors have the freedom to sell any quantity of share to the ESOP, as well as whatsoever quantity of share is sold to the employee stock ownership plan will be subject to taxes at capital gains tax rates. It must also be observed that when an ESOP has purchased at least thirty percent of the remaining share, all share sales to the ESOP after that will also be entitled to the tax-deferral treatment.

Myth #5: Selling share to an ESOP will end up in a loss of management by the proprietor Not always correct. Selling share to an ESOP does not need to end up in any loss of management by the present proprietor. In many cases, the present Board of Director members work as the ESOP Trust fiduciaries. Therefore there isn’t any loss of voting power.

Myth #6: A proprietor might get a better price by selling to a 3rd party instead of selling to an ESOP Not necessarily correct. An ESOP is allowed to pay the same price which any 3rd party would pay for a similar block of share. Therefore, in case an ESOP buys a minority interest, the share must be valued at a minority discount. On the other hand, in case the ESOP buys a controlling interest (including the same voting privileges which a 3rd party would have) in that case the ESOP may pay a control premium for the share. Selling a company to a 3rd party purchaser, on the contrary, can be extremely time-consuming and expensive, and there’s no assurance of a positive result. There are several companies that were at one time for sale where no 3rd party purchaser was found, and the proprietors then looked to an ESOP as the answer.

Myth # 7: An ESOP should be leveraged in order to buy organization share Incorrect. An ESOP does not need to necessarily be leveraged. For instance, an ESOP might buy share on a year-by-year basis without participating in any leverage. As one more option, an ESOP may be prefunded for several years with yearly cash contributions which are built up and after that used to buy a chunk of share at the conclusion of the 4th or 5th year of the program.

Myth #8: The members will be capable to exercise normal voting privileges when their stocks become vested Incorrect. Workers are members in a trust. Therefore, for private organizations the ESOP fiduciaries have the voting control in many situations, including selection of the Board of Directors. Members have got usual voting privileges only in the case of public organizations.

Myth #9: Members should be permitted to vote their shares on any suggested sale of the company Incorrect. Voting privileges should be passed through in the situation of the sale of all or considerable part of a company, reorganization, dissolution, liquidation or a merger. But, there isn’t any obligation that voting privileges be transferred through in the situation of a sale of portion or the entire remaining share of an organization to a 3rd party. Most of corporate purchases are organized like share purchases instead of like a buy of assets.

Myth #10: Having an ESOP will make it more challenging to sell the company to a 3rd party in the long term The ESOP is simply one additional investor of the organization. If the organization has, for instance, four investors instead of three investors, makes virtually no difference to the purchaser. There is just one example where having an ESOP makes it more challenging to sell the company to a 3rd party. In case an ESOP sells its share to a 3rd party, it can’t get a promissory note for any portion of the buy price. The ESOP should get all cash or share. Therefore, in case the buyer programs to utilize a promissory note for any part of the buy price, after that the remaining investors must get a higher portion of seller notes.

Myth #11: An ESOP should buy organization share as quickly as possible after the program is set up Incorrect. As stated before, the only condition is that the ESOP should be mainly invested in shares of organization share during the life of the program. But, there isn’t any condition that the ESOP be mainly invested during shares of organization share every year. Therefore, an ESOP may be “prefunded” with cash contributions for the initial years. This renders it possible to build up cash for the buy of a chunk of share later when the value is at a suitable stage. Building up cash in the program for a duration of years also decreases the leverage which may otherwise be needed to buy a specific block of share.

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