An Employee Stock Ownership Plan (“ESOP”) is a tax qualified retirement plan which is designed to invest primarily in stock of the sponsor corporation. Under §4975 of the Internal Revenue Code of 1986, as amended (the “Code”) and §§406 and 408 of the Employee Retirement Income Security Act of 1974 (“ERISA”), ESOPs are the only type of retirement plan that can borrow money from (or obtain loans guaranteed by) a party in interest (an “exempt loan”).

1. ESOPs in Business Succession
Planning
By Steven B. Greenapple
973.540.9200 ext. 101
sgreenapple@sfeglaw.com
Introduction
An Employee Stock Ownership Plan (“ESOP”) is
a tax qualified retirement plan which is designed
to invest primarily in stock of the sponsor
corporation. Under §4975 of the Internal Revenue
Code of 1986, as amended (the “Code”) and
§§406 and 408 of the Employee Retirement
Income Security Act of 1974 (“ERISA”),
ESOPs are the only type of retirement plan that
can borrow money from (or obtain loans
guaranteed by) a party in interest (an “exempt
loan”). This enables an ESOP to use financial
leverage to make substantial purchases of
company stock and, in combination with
significant ESOP tax benefits, explains why
ESOPs are often used to facilitate internal
ownership
transitions
of privately held
companies. At the same time, a large volume of
overwhelmingly positive ESOP research shows
that ESOP companies are more productive and
profitable than their non-ESOP counterparts.1 The
National Center for Employee Ownership
estimates that ESOP companies grow 2 to 3%
faster than their non-ESOP counterparts, enjoy
lower employee turnover and achieve 2.5%
greater productivity.2
Notwithstanding the substantial tax and financial
benefits of ESOPs and the empirical research
demonstrating that ESOPs increase productivity,
ESOPs are not as prevalent as one would expect,
1
Steven F. Freeman, Effects of ESOP Adoption and Employee
Ownership: Thirty Years of Research and Experience, working paper
#07-0 1 (University of Pennsylvania 2007), posted at
ScholarlyCommons@Penn
http://repository.upenn.edu/cgi/viewcontent.cgi?article=1001&context=o
d_working_papers.
2
Corey Rosen, Research on Employee Ownership Corporate
Performance and Employee Compensation, National Center for
Employee Ownership, http://www.nceo.org/main/article.php/id/3/.
perhaps because the legal framework is complex
and not well understood. Loren Rodgers,
Executive Director of the National Center for
Employee Ownership, estimates that there are
about 10,500 ESOPs in the United States, more
than 95% of which are sponsored by nonpublic
companies. The Small Business Jobs Protection
Act of 1996 (“SBJPA”), allowed ESOPs to own
stock of S corporations. Beginning in 1998, ESOPowned S corporations were not taxable on their
allocable share of the company’s earnings. In
addition, ESOPs are wholly (or partially)
exempt from state income taxes in most states.
Only fifteen years after enactment of the SBJPA,
Rodgers estimates that there are more than 3,500
majority or wholly owned S corporation ESOPs.
The following sections summarize the special
treatment of ESOPs, explain how leveraged ESOPs
work and discuss key ESOP valuation concepts that
apply to ESOP transactions.
Special ESOP Qualification
Requirements
Most ESOPs are stock bonus plans that satisfy
additional ESOP qualification requirements in
§§401, 409 and 4975 of the Code.
Qualifying Employer Securities – Code §409(l)
An ESOP must be designed to invest primarily
in “qualifying employer securities” which means
generally 1) voting common stock of the employer
(or another company in the same controlled group
of corporations) with a combination of voting and
dividend rights equal to the highest class of
common stock, or 2) preferred stock convertible
at any time into common stock at a conversion
price which is reasonable at the date the ESOP
acquired the employer securities.
ESOP Put Option – Code §409(h)
ESOP participants must generally be given the
right to demand a distribution of their account
balance in the form of qualifying employer
securities. However, if the company is an S
corporation, or its bylaws or charter restrict
ownership of substantially all qualifying employer

2. securities to employees or a qualified retirement
trust, distribution may be made in cash or in
employer securities that are subject to immediate
repurchase by the employer. Distributed shares
must contain a put option obligating the
employer to repurchase the shares at a fair value
in the year of distribution and again in the
following year. If employer securities are
distributed in a total distribution, payment under
the put option may be made over a period not
in excess of five years (longer if the shares are
valued at more than $985,000), but the employer
must provide adequate security and pay interest at
a reasonable rate on the unpaid balance.
ESOP Distributions – Code §409(o)
Unless a participant otherwise elects, ESOP
distributions on account of normal retirement,
disability or death must begin not later than one
year after the year in which the participant
separated from service; distributions to participants
whose employment is terminated for other reasons
must commence not later than the sixth plan year
after the year in which the participant separated
from service. An exception allows distribution of
employer securities acquired with the proceeds of
an exempt loan to be deferred until the year after
the year in which the exempt loan is repaid.
Annual Appraisal – Code §401(a)(28)(C)
Nonpublicly held employee securities held in
an ESOP must be appraised annually by an
independent appraiser.
ESOP Diversification – Code §401(a)(28)(B)
Participants age 55 or older with ten or more years
of participation in the ESOP must be given the
right to diversify up to 25% of the employer
securities that have ever been allocated to their
ESOP account. Diversification must be offered
annually for five years; in the sixth and final year
of statutory diversification the elective
percentage increases to 50%. An ESOP may
satisfy the diversification requirement by
distributing cash (or qualifying employer
securities subject to immediate repurchase), by
offering at least three investment options under
the plan, or by transferring the diversified funds to
another employer sponsored plan that allows for
participant investment direction.
ESOP Tax Benefits
ESOP Rollover – Code §1042
This allows a selling shareholder (other than a C
corporation) to defer recognition of capital gain
on the sale of “qualified securities” to an ESOP if
the proceeds are rolled over and reinvested in
“qualified replacement property” within a
fifteen month window beginning three months
before the ESOP sale and ending twelve months
after the sale. “Qualified securities” means C
corporation stock that has been held by the
selling shareholder for at least 3 years, and was
not acquired through exercise of an
employment-related option or a compensatory
transfer to which Code §83 applied. Code §409(n)
restricts the ability of the seller, certain family
members and 25% or greater shareholders to
participate in ESOP allocations after a rollover
sale. “Qualified replacement property” generally
means securities issued by an active domestic
operating corporation that satisfies certain
passive income limitations, and were not issued
by the employer or a member of the same
controlled group of corporations. The qualified
securities purchased by the ESOP in a rollover
transaction are subject to a 10% penalty tax
payable by the employer if they are sold or
otherwise disposed of within three years after the
ESOP purchase, except for normal distributions
on account of retirement, death or disability.
ESOP Deductions – Code §404
ESOP leveraged loans receive very favorable
treatment. Under Code §404(a)(9)(A); a C
corporation may deduct ESOP contributions
used to repay an exempt loan up to 25% of the
covered
compensation
of
participating
employees.
Under
Code
§404(a)(9)(B),
contributions used to repay interest on an
exempt loan are deductible without limitation.
The Code §404(a)(9) rules applicable to deductions for leveraged ESOP contributions apply in
addition
to
allowable
deductions
for
3
contributions to other employer plans.
3
See PLR200436015.

3. Under Code §404(h) reasonable dividends on C
corporation stock that are applied to repay an
exempt loan or are paid or passed through to
participants in cash are deductible. However, if
dividends on allocated shares are used to repay
the loan, employer securities with a fair market
value at least equal to the dividends paid on the
allocated shares must be allocated to participants’
accounts.
Expanded Annual Additions – Code §415(c)(6)
Code §415(c)(6) increases the dollar value of the
annual additions that may be allocated to
participants’ accounts in C corporation ESOPs
with an exempt loan deductible under Code
§404(a)(9). If not more than one-third of the
employer contributions are allocated to highly
compensated employees, forfeitures and interest
on the leveraged loan are not included as annual
additions.
S Corporations
S corporation stock sales are not eligible for
rollover treatment, or for the increased tax
deductions and allocations that apply to C
corporations. S corporations are also subject to
complex anti-abuse rules set forth in Code
§409(p) that effectively limit the use of ESOPs
in S Corporations with fewer than 20 employees.
Still, the growth of ESOPs-owned S corporations
has been dramatic. A primary reason is that the
tax savings enjoyed by S corporation ESOPs can
enable a 100% ESOP buyout to be completed
within a compressed 5-7 year timeframe.

4. Leveraged ESOPs
Most ESOPs established to finance ownership
transactions are leveraged, which means they use
an exempt loan to acquire a significant ownership
stake in the company. In a “traditional” ESOP
transaction (see the Figure 1 illustration) the
lending bank extends credit to the company, which
in turn re-loans the proceeds to the ESOP. For
fiduciary reasons, it is preferable to break the
ESOP loan into two loans; the “outside” loan from
the lender to the company followed by an “inside”
loan from the company to the ESOP. In this
structure, the inside loan is the exempt loan. The
note from the ESOP is secured by a pledge of
the acquired securities. The loan repayments
illustrated in Figure 2 could be made from either
employer contributions or deductible dividends
on the qualifying employer securities acquired
with the exempt loan. Figure 3 shows a typical
transaction resulting in 100% ownership of an S
corporation. Leveraged ESOP transactions often
require seller financing, which is usually in the
form of a subordinated note, sometimes
accompanied by warrants. Because an ESOP sale
of S corporation stock is not eligible for a Code §
1042 rollover, the company often redeems the
shares and then resells them to the ESOP; in
other respects the transaction is similar to the
typical leveraged ESOP shown in Figure 1.
Beyond typical best practices in business
valuation generally, there are some unique
issues specific to ESOPs that need to be
considered by the valuation professional:
•
ESOP Debt and Associated “Tax Shield”:
After a leveraged ESOP is established, the
sponsoring company’s balance sheet now
includes the debt associated with the
purchase
and,
consequently,
the
company’s post-transaction equity value
will be lower. However, the future
benefits associated with the fact that the
ESOP debt is fully deductible has a
partially offsetting positive impact on the
value of the ESOP owned company. As
the debt is repaid, the “tax shield” benefit
incorporated into the valuation is reduced.
Consider the following illustration
where a newly formed leveraged ESOP
purchases a 40% ownership interest of the
common stock in the sponsoring company:4
Pre-ESOP
Market Value of Invested
Less: Existing Debt
Less: ESOP Related Debt
Plus: ESOP Tax Shield
Market Value of Equity
Post-ESOP
$ 75,000,000
(20,000,000)
$ 55,000,000
$ 75,000,000
(20,000,000)
(22,000,000)
3,000,000
$ 36,000,000
ESOP Valuations
An ESOP trustee must obtain an independent
valuation from the ESOP appraiser to
determine that the ESOP has not paid more
than “adequate consideration” for the shares
acquired in an ESOP transaction in order for
the purchase to be exempt from the
prohibited transaction rules of ERISA and the
Code. Company valuation is critical to the
establishment and maintenance of an ESOP;
failure to properly value employer securities
held in the ESOP can lead to prohibited
transaction taxes under Code §4975, penalties
under ERISA §502(l) and substantial
administrative and compliance costs.
In subsequent annual valuations, it is
also important to consider how the
sponsoring company’s capital structure
may affect cash flows and may limit
the company’s access to additional
debt to help fund future growth.
•
4
Discount for Lack of Marketability: Stock
in a closely-held company is by definition
an illiquid security and subject to a
significant pricing discount for lack of
marketability. However, the put option on
distributed ESOP shares effectively creates
Adapted from Robert F. Reilly and Robert P. Schweihs,
Willamette Management Associates Guide to ESOP Valuation
and Financial Advisory Services (2005).

5. a market for the shares, thereby reducing
the marketability discount and increasing
the value of the shares.
•
•
Repurchase Liability: Although the
repurchase obligation
reduces
the
marketability discount on ESOP shares,
this obligation is a future liability of the
sponsoring company. As time passes, this
repurchase liability becomes more and
more important as 1) the ESOP shares
vest, 2) the value of the ESOP company
increases over time and 3) participants
begin to age and retire. If not properly
planned for, this repurchase obligation
may put a strain on the company’s future
cash flows and adversely affect annual
valuations.
ESOP Contribution Expenses and/or ESOP
Dividends: ESOP contributions and
dividends used by the ESOP to pay an
exempt loan are classified as an ESOP
contribution expense on the sponsoring
company’s income statement. To the extent
they exceed normal retirement benefits, the
appraiser must reduce or normalize these
ESOP expenses in the valuation of the
company.
•
ESOP Setup Expense: Legal, valuation and
related professional fees associated with
establishing an ESOP can be substantial.
These setup costs are typically adjusted to
be amortized over the life of the ESOP
loan.
•
Annual Share Value Volatility: ESOP shares
are considered long-term retirement
benefits to the ESOP participants.
Accordingly, the appraiser needs to incorporate a long-term investment horizon in
the
valuation
process
without
compromising professional standards. This
may result in some smoothing of value
from year to year.
Characteristics of Good ESOP
Candidate Companies
Not all companies are good candidates for
ESOPs. For example, family owned companies
with a succession plan that continues to include a
legacy of family ownership may not want to
consider an ESOP. Companies with some or all of
the following traits may benefit from
consideration of an ESOP structure:
1. Ownership Profile: The current owners are
committed to supporting the ownership
transition and are flexible enough to offer
some seller financing.
2. Cash Flow History: The sponsoring
company has a history of significant cash
flow to support additional ESOP debt.
Typically a minimum of $400,000 to
$500,000 in historical pre-tax profits,
adjusted to reflect normal executive
compensation, is a good starting point.
3. Staff: The sponsoring company has
enough staff to have an active upper
management level and preferably a
second-tier management team in place.
4. Value vs. Payroll: The company value to
total payroll ratio is low enough to make
the deal work. If the company is valued
at $100 million with a payroll of just $2
million, it may be difficult to service
ESOP
debt
through
company
contributions, even if dividends (or S
distributions) are used for this purpose.
5. Growth expectations: The sponsoring
company has reasonable growth prospects
with respect to geographic markets
served, expanding market share and the
anticipated general growth of the industry.
Companies with poor growth prospects,
and companies with explosive growth
potential are doubtful candidates; the
former for obvious reasons, the latter
because sudden dramatic increases in a

6. company’s repurchase liability can
make financing the repurchase liability
problematic.
plan will help build a solid ownership
culture in the new ESOP company.
Conclusion
6. Costs: Setting up an ESOP can be a less
expensive liquidity option than engaging
an investment bank or receiving private
equity financing. However, a sponsoring
company
should
have
adequate
wherewithal to cover the fees of the
ESOP’s professional advisors (legal,
valuation and in some cases, an
independent fiduciary) as well as its own.
7. Existing Benefit Plans: Companies with
an existing profit sharing or other
employee benefit plan may be able to
divert future payments to the ESOP
without incurring additional employee
compensation costs. In some cases,
accounts in another qualified plan can be
electively transferred directly into the
new ESOP and used to fund the ESOP
purchase.
8. Cultural Fit: A successful ESOP
implementation hinges on a transition
from a company of employees to a
company of owners. Although difficult to
assess, a good ESOP candidate exudes
an eagerness to embrace this cultural
shift. An ongoing ESOP communication
As the baby boom generation reaches retirement
age, ownership of more and more closely held
companies will change. For a business owner
considering ownership transition, ESOPs offer a
number of advantages:
•
Significant tax and financial benefits
•
The ability to finance an internal
ownership transition for the benefit of
current employees
•
ESOP sales can be structured in stages,
leaving the owner in control of the
business until the ownership transition is
completed
•
An ESOP can enhance the company’s
future growth and profitability when a
successful employee ownership culture
has been established
For these reasons, business advisors need to be
familiar with the uses and applications of
ESOPs as a powerful tool for business
succession.
Steven B. Greenapple has extensive experience in transactions involving Employee Stock Ownership Plans, as well as
designing and implementing other forms of equity compensation plans such as stock appreciation rights, phantom stock plans
and stock option plans. Steve is frequently brought into transactions as special ESOP counsel by clients’ corporate counsel. He
has also served as an expert in litigation related to ESOPs in State and Federal court.
Steiker, Fischer, Edwards & Greenapple, P.C., provides legal advice related to ESOP plan design, structures and transactions,
as well as other employee-centered succession and compensation strategies. Attorneys counsel fiduciaries, lenders, selling
shareholders and ESOP plan sponsors. With our sister consulting form, SES Advisors, Inc., the firms offer business succession
planning and ownership transition strategies, ESOP feasibility and transaction analysis, ESOP design & installation, Bank
financing & private placements, combined ESOP & 401(k) Administration solutions, and strategic ESOP sustainability
consulting.