Geneva

Topical Briefing
February 2004

EMPLOYEE STOCK OWNERSHIP PLANS

How an ESOP Works

■ An Employee Stock Ownership Plan (ESOP) is an employee benefit plan that makes
employees stockholders in their company.
■ A company interested in establishing an ESOP has a wide range of options in tailoring
a plan that is best suited to its particular needs and goals.
■ For example, ESOPs can be organized to hold varying levels of a company’s stock.
Most ESOPs own only a minority interest of the company. According to the National
Center for Employee Ownership, only 30% of all ESOPs are set up to own a majority
share or 100% of the company.
■ To create an ESOP, a company sets up a trust to which it makes annual contributions.
These contributions, which are tax-deductible, are typically allocated to individual
employee accounts within the trust based on compensation and vested on the basis of
years of service.
■ The shares of company stock and other plan assets allocated to employees’ accounts
must vest before employees are entitled to receive them.
■ Employees receive the vested portion of their accounts at either retirement,
termination, disability, or death.

The Leveraged ESOP

■ ESOPs differ from other employee benefit plans in their ability to borrow money in a
tax-advantaged manner.
■ The leveraging is usually intended to buy out owners’ stock, divest a division, provide
capital for expansion or capital improvements, or make acquisitions.
■ In a leveraged ESOP, the company typically guarantees the lender that it will make
tax-deductible contributions to the trust which will enable the trust to amortize the
ESOP loan on schedule.
■ Two tax incentives make borrowing through an ESOP attractive. First, since ESOP
contributions are tax-deductible, a corporation that repays an ESOP loan in effect pays
principal as well as interest from pre-tax income. This can cut the cost of financing
significantly. Second, dividends paid on ESOP stock and used to repay the ESOP loan
are tax-deductible, thereby increasing the amount of cash available to the company
compared to conventional financing.

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 EMPLOYEE STOCK OWNERSHIP PLANS

Growth of ESOPs

■ ESOPs have been around for a long time. The concept was developed in the 1950s and the legislation that first
implemented tax advantages for ESOPs was passed in 1974.
■ The total number of ESOPs in the United States (includes true ESOPs, company stock bonus plans, and profit
sharing plans primarily invested in employer stock) has almost tripled since 1980, increasing from 4,000 plans to
approximately 11,000 in 2003, according to the National Center for Employee Ownership (NCEO).
■ The number of ESOP participants is currently estimated to be around 8.8 million, representing 8% of the U.S.
private sector workforce.
■ According to the NCEO, as of 2003, ESOPs controlled over $400 billion in assets – over twice as much as was
controlled in 1994, and more than three times the amount controlled in 1990.
■ Although people are most familiar with the ESOPs of large, public companies such as Proctor & Gamble and
Anheuser-Busch, most ESOPs are
established in smaller, closely held
businesses. The ESOP Association states Growth of Employee Ownership* in the U.S.
that approximately 90% of ESOPs are
operating in private companies. 12,000
■ ESOP legislation continues to evolve, 10,000
providing ongoing incentives and 8,000
advantages to both sponsoring companies Number of
Plans 6,000
and employees, and stimulating new plan
growth. With Congress’ enactment of the 4,000

Economic Growth and Tax Relief 2,000

Reconciliation Act of 2001 (which became 0
effective in 2002), a number of new 1975 1980 1990 1993 1996 2001 2002 2003

employer tax incentives and expanded

employee contribution limits make ESOPs
* Includes ESOPs, stock bonus plans, and profit sharing plans
even more appealing. primarily invested in employer stock.
Source: The National Center for Employee Ownership
Benefits of an ESOP

■ ESOPs offer a unique business structure legislated by Congress and embedded in the IRS code to encourage
business owners, vis-a-vis substantial tax benefits, to provide stock ownership to employees.
■ The multiple benefits of an ESOP include:
! Liquidity with control: An ESOP is an efficient mechanism by which a business owner can sell a minority
interest at full fair-market value and still maintain total control of his or her company.
! Personal Tax Benefits to Business Owners: An ESOP is a versatile financial tool that can be used by
shareholders to obtain tax benefits in selling all or a portion of their company. According to the NCEO, if
the ESOP owns at least 30% of the company after buying stock from the owner, the owner can defer capital
gains taxes on the proceeds of the sale – provided the proceeds are invested in other securities such as
stocks and bonds of domestic corporations. No capital gains tax is paid until those investments are sold. If
held until death, the securities are stepped-up in basis and, although estate tax is paid, the original capital
gains tax is eliminated.
! Corporate Tax Benefits: A firm borrowing money through an ESOP can repay the loan by making fully tax-
deductible contributions to the ESOP. As a result, the tax code in effect allows a company to repay both
principal and interest on an ESOP loan in pre-tax dollars.

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! Confidentiality: Under an ESOP, business owners can maintain absolute confidentiality with regards to
revenue and profit figures, owner’s compensation, employee compensation plans, proprietary advantages,
and other business secrets. The only financial information a company must divulge once a year to each
ESOP plan participant is the fair market value of the company’s stock as determined by an independent
financial advisor.
! Corporate Performance: Studies have indicated a positive correlation between ESOPs and corporate
growth. A recent study by the NCEO looked at sales, employment, and sales per employee and found that
ESOP companies grew 2.3% to 2.4% faster than expected based on their growth before the ESOP was
instituted. Another NCEO study found the return on assets for 382 publicly traded ESOP companies was
2.7% greater per year than what was expected without an ESOP.
! Employee Motivation: In addition to providing tax advantages, ESOPs offer the added benefit of making it
easier for a company to attract, retain, and motivate talented employees. In fact, employee productivity
usually accompanies an ESOP, thereby creating a competitive advantage for a company. NCEO research
shows that giving workers a significant stake in their companies increases their dedication, improves their
work effort, and reduces absenteeism and turnover.

ESOP Drawbacks

■ As appealing as ESOP benefits are to many corporations, there are some important drawbacks and caveats that
owners should be aware of, including the following:
! ESOPs may not be used in partnership structures and most professional corporations.
! Although ESOPs can be used in S-corporations, there are certain restrictions and lower contribution limits.
! Because of their dual roles as corporate finance and retirement savings vehicles, ESOPs often give rise to
conflict of interests that can lead to significant liabilities under ERISA if not properly handled. Particularly
for smaller companies where an ESOP’s fiduciaries might also serve as officers or directors, conflicting
duties to the company and the ESOP’s participants may be difficult or impossible to resolve without
independent legal, investment, and financial counsel.
! The basic costs involved with setting up an ESOP can be high – starting at $15,000 to $20,000 for the most
basic plans in small companies and going up from there.
! The requirement for private companies to repurchase shares of departing employees can become
expensive.
! The stock of existing owners is diluted any time new shares are issued, which must be considered against
the tax and other benefits an ESOP can provide.
! Although multiple studies have revealed that ESOPs can improve corporate performance, it has been found
that employees must be able to participate in decisions affecting their work for this effect to be realized.

Who Qualifies for an ESOP?

■ The NCEO states that, as a rule of thumb, ESOPs work best for companies with over 15 employees, due to the
costs of setting up and administering an ESOP program.
■ Since tax deductions are irrelevant without taxable income, ESOP candidates should be profitable enough to make
the costs of the plan worthwhile.

Setting-Up an ESOP

■ Setting up an ESOP requires expert consulting, legal and accounting advice. Generally, the process includes these
steps:

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! Obtain a feasibility study to determine the ESOP’s ability to repay the loan, as well as how the ESOP can
be structured to meet ownership objectives.
! Determine the value of the company’s stock. Value must be rendered by an independent outside valuation
expert. This is obviously a critical step for the business owners, as the higher the value the more beneficial
the ESOP. Expert ESOP advisers can help present your company to the independent valuation team in a
way that promotes maximum value.
! Secure funding for the plan.
! Establish a process to operate the plan, including appointing a trustee, setting up an ESOP committee, and
communicating regularly with employees.
■ While the potential benefits of an ESOP are great, this complicated process should be expertly managed by an
experienced and qualified ESOP consultant.

For additional information on Geneva’s services, please contact:

The Geneva Companies 5 Park Plaza, Irvine CA 92614 | (800) 854-4643 | www.genevaco.com
Although the information in this sales literature has been obtained from and is based upon sources The Geneva Companies Inc. ("Geneva") believes to be reliable, we do not guarantee its
accuracy and it may be incomplete or condensed. All opinions and estimates constitute Geneva's judgment as of the date of the document and are subject to change without notice. Past
performance is no guarantee of future results. This sales literature is for informational purposes only and is not intended as an offer or solicitation for the purchase or sale of a security. Geneva
shall not be liable for any actions taken in reliance upon this sales literature. The information herein does not take into account the investment or tax objectives or financial or legal situation of
any particular person or entity. You should obtain advice from your financial, tax or legal advisors based on your own individual circumstances before making an investment decision. Neither
Geneva nor any other person accepts liability whatsoever for any loss (howsoever arising and whether direct or consequential) from any use of the information contained herein or otherwise
arising in connection herewith. Geneva is an affiliate of Smith Barney, a division of Citigroup Global Markets Inc. Geneva may receive compensation for referrals of Geneva Clients or
prospective Clients to Smith Barney. Smith Barney may receive compensation for referrals of Smith Barney Clients or prospective Clients to Geneva.
© The Geneva Companies Inc., February 2004. All rights reserved. Any unauthorized use, duplication, or disclosure is prohibited by law and will result in prosecution.

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