The Flexible ESOP Tax-Shield

While most executives are familiar with the conventional leveraged Employee Stock Ownership Plan, a less-understood, but sometimes more powerful vehicle capable of acquiring stock and providing the ESOP benefit of tax deductible principal payments is the so-called “trickle-down” or “progressive” ESOP. The technique is applicable to a broad spectrum of divestitures, acquisitions and other transactions where the objective is to make tax deductible debt principal payments.

The “progressive” ESOP provides an opportunity for maximizing the equity position of non-ESOP stockholders with a full corporate tax deduction for all principal and interest payments on the acquisition debt, with the objective of minimizing dilution for these equity investors.

The sequence of the transactions:

  1. The company obtains financing to consummate a transaction.
  2. The ESOP is installed prior to the end of the first fiscal year for which the tax-deductions are desired; the actual contributions need not be made until the filing of the corporate return (including extensions).
  3. As the principal payments are made each year by the corporation to repay the debt, newly-issued stock is contributed to the ESOP in the amount of the principal payments – i.e., the stock “trickles down” into the plan as the ESOP “progresses” upward. This effectively means that these debt payments are made with pre-tax dollars.
  4. If the stock value continues to rise, fewer and fewer newly-issued shares are needed to tax shelter these fixed amount payments; this results in less dilution to the existing shareholders than would be the case with the usual leveraged ESOP, which acquires all of the stock sold at the outset.

Advantages

  1. Greater Control: Contributions are made to the plan as needed, depending on tax and equity considerations. (The lender may require a fixed minimum annual contribution commitment.)
  2. Equity Growth: The remaining shareholders’ positions are proportional to corporate performance as reflected in stock value growth. This structure can thus sometimes avoid the need for complex securities designs.
  3. Flexibility: The plan could actually be a stock bonus plan or profit sharing plan. These plans would be permitted to receive contributions of different types of company stock, such as preferred stock with no conversion feature, or nonvoting common stock.
  4. With a suitable transaction design, additional non-ESOP stock can be made available to a management group, thus fine-tuning equity incentives as desired.
  5. The gain in the market value of the company can more than compensate for any dilution to current stockholders, resulting in a net greater value to them than with the conventionally leveraged ESOP
  6. No one is excluded from participating in the ESOP.

Disadvantage

  1. If the stock value does not grow as forecasted, the dilution to existing shareholders would be increased. However, if the value were to decrease, there would probably be less of a need for a tax deduction and the board of directors could choose to contribute less stock to the plan.