The Employee Stock Ownership Plan (ESOP) is a special form of qualified
profit sharing plan that invests primarily in employer securities. While ESOPs are subject to all
of the normal requirements of a qualified retirement plan such as participation, vesting, contribution
limitations, and non-discrimination, ESOPs are unique in that the plan is permitted to purchase
employer stock, and take out loans to purchase the employer stock, without violating the
prohibited transaction rules. Because of the ability to purchase employer securities, ESOPs
provide unique planning opportunities generally not available with other qualified plans.
The following charts illustrate three different ways to structure an ESOP.
Corporation makes tax-deductible
contributions of cash to ESOP
ESOP uses cash to purchase stock
Employer borrows funds from lender
Employer loans funds to ESOP
ESOP purchases stock with borrowed funds
Employer makes tax deductible contributions to ESOP
ESOP uses employer contributions to repay loan principal & interest
Employer uses ESOP principal & interest
payments to repay loan from lender
Establishes ESOP
Business Owner sells stock to ESOP.
Capital gains tax is deferred on sale.
Business Owner uses sale proceeds to
purchase qualified replacement property. No tax until qualified replacement property is sold.
A private company, that maintains an ESOP for its employees will
experience a potentially large cash problem in the future. This is due
to the fact that all private companies are obligated to repurchase the
shares the ESOP distributes to the employees. This obligation necessitates
careful planning. Corporate owned life insurance could be the tool that
meets the needs of a company faced with just such a problem.
An Employee Stock Ownership Plan (ESOP) is a special form of qualified
profit sharing plan1 that invests primarily in employer securities.
Deductible contributions are made from the corporation to the ESOP
in the form of employer stock.
This stock is then allocated to the individual participant employee’s
account inside the ESOP. Following termination of employment, by
way of retirement, dismissal, resignation, or death, the ESOP will begin
distributing, to the employee, his vested shares.
All private companies will have to repurchase these shares upon the
request of the employee.
This repurchase obligation often places an immense strain on the
future cash flow of a company. A plan must be developed to fund this
obligation and alleviate the strain on the future cash flow. In addition,
the proposed plan must be flexible enough to provide funds of various
amounts at various times because the timing of the repurchase obligation
is uncertain.
As a funding method, variable universal life insurance has two distinct
advantages. The first advantage, favorable taxation, is actually two-fold.
First, it can accrue cash surrender value, which may grow income taxdeferred
and be accessed on a tax-advantaged basis. Secondly, a life
insurance policy’s death benefit is generally received by the corporation
free of federal income taxation.
The other major advantage of life insurance is timing. By using variable
universal life, the corporation may be able to provide the necessary
funds regardless of when the obligation arises, provided the policy
has sufficient cash value accessible to the company.
Because most employees will receive their benefits during life, the
repurchase obligation is more likely to be funded through the withdrawal
and loans of the policy’s cash surrender value rather than the
death benefit. However, the death benefit proceeds can be used in the
case of premature death. This flexibility allows the corporation to
structure the policy to best meet their anticipated, and even unexpected,
needs.
An important question when using life insurance to fund the repurchase
obligation is on whom does the corporation place the policy. The
answer to this question will vary depending upon the specific circumstances
of the case. As an example, one particular strategy is to place
the insurance on certain key employees. This way the life insurance
performs “double duty” by helping fund the repurchase obligation
and also compensating the company for the death of a key individual.
Another strategy is to insure individuals who have rather large account
balances.
Step 1:
The corporation makes deductible contributions
of stock to the ESOP. This allows for an income tax savings without an expenditure of cash.
Step 2:
The corporation uses this cash savings to make premium payments
of the life insurance policy. The corporation is the owner and sole beneficiary of the policy and as such,
has access to the cash surrender value.
Step 3:
The ESOP distributes stock to the participant
following the end of his employment with the company.
Step 4:
The participant, or his estate if employment
ended due to death, elects to demand the company to repurchase the shares.
Step 5:
The company accesses either the cash surrender
value, or uses the death benefit to fund this obligation.
