Our Approach

Owners of privately held businesses have dedicated their lives to growing a business about which they are passionate. Frequently, though, they might not have taken the time to fully explore and consider all the choices they have available to them as they prepare for the next stage of their lives. Therefore, as Financial Advisors and Wealth Managers, we consult with business owners of all types to deliver in-depth advice that can help them gain liquidity, diversify wealth and reduce risk, while providing their employees with incentives through stock ownership. Often the best way to do this is with the use of Employee Stock Ownership Plans (ESOPs), which may enable business owners to remain as involved in their business as they desire, yet retire with confidence.
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What is an ESOP?

An Employee Stock Ownership Plan is a qualified defined contribution employee benefit plan, much like a traditional profit-sharing plan. However, an ESOP is unique among qualified benefit plans in its ability to borrow money. In that way, an ESOP can be used as a corporate finance technique that provides liquidity to business owners.

Through an ESOP, business owners can achieve partial or total liquidity and diversification, usually in a tax-advantaged manner. At the same time, the ESOP can benefit employees by making them stockholders in their company. In fact, an ESOP is the only mechanism that offers a meaningful benefit to employees, while providing private business owners with a market for their stock and companies with a means of borrowing money in a tax- advantaged fashion.

Business owners look to ESOPs as an attractive liquidity alternative, one they can use to take some or all of their "chips" off the table, providing liquidity to the owner in a tax-advantaged manner. The strategy permits them to diversify their wealth, yet allows them to remain involved in their business if they so desire. As baby boomer business owners age, they are redefining retirement, often with an interest in remaining at least partially involved in their business. For this new generation of "semiretirees," ESOPs may be one solution.

For more detailed information on ESOPs, please see our team brochure.

How an ESOP Works

To establish an ESOP, the company first borrows money to finance the purchase of stock from the current shareholder or shareholders, and the company lends these funds to the ESOP. A trust is created to purchase the stock of the company on behalf of the ESOP plan.

From its operating profits, the company then makes annual cash contributions to the trust. These contributions are potentially fully tax-deductible. As the trust uses this cash to pay down the ESOP loan, shares of stock are released and allocated to individual employee accounts based on compensation, and then vested on the basis of years of service.

Employees are typically vested in the stock within three to six years of receipt, but they may not actually sell the stock until they leave the company. At that time, the plan may provide that the company can buy back their shares at fair market value, as determined by an independent business valuation firm appointed by the ESOP trustee. The following chart shows the structure and flow of an ESOP.

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    ESOPs have existed 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. From only a handful in the 1970s, their numbers have grown to nearly 6,700 plans in existence today.

    The National Center for Employee Ownership (NCEO) estimates that ESOPs have 14.4 million plan participants and control more than $1.29 trillion in plan assets.2 ESOP legislation continues to provide incentives and advantages to both sponsoring companies and employees, adding to the attractiveness of this liquidity option.

    Because of the broad appeal of these plans, ESOP candidates vary considerably. Most ESOPs (approximately 97%) are established for privately held companies. Any company—whether a manufacturing, distribution or service business—that can borrow enough money to fund the ESOP is a viable candidate. However, high-end service businesses with educated workforces—such as architecture, engineering or consulting firms—tend to be better represented in the current universe of ESOPs.

    While each situation needs to be assessed individually, the following characteristics tend to identify a potential candidate:

    • In order to maximize an ESOP (i.e., effectuate a tax-advantaged sale of stock for the ESOP) the company must currently be, or be willing to convert to, a C corporation. S corporations do not give sellers to ESOPS owning at least 30% of the stock the ability to defer taxation on the gain.
    • The company must have sufficient capacity (collateral or cash flow) to support funded debt.
    • A successor management team should be in place.
    • Owners must be open to the concept of broad-based ownership.
    • The company should have been in business for several years and have enough employees to make the plan worthwhile.
    • The company should be able to reasonably predict future revenue and cash flows (this is probably more important than having hard assets to support the loan).

      Is an ESOP Right for You?

      As appealing as the benefits of an ESOP can be, there are some important issues that business owners should take into consideration:

      • ESOPs may not be used in partnership structures or in most professional corporations.
      • Although ESOPs can be used in S corporations, there are certain restrictions and lower contribution limits for S corporations than for C corporations.
      • The ESOP is both a corporate finance and retirement savings vehicle. If not handled properly, these dual roles might create a conflict of interest under ERISA. For smaller companies, where an ESOP’s fiduciaries might also serve as officers or directors, these conflicts might be difficult to resolve without independent legal, investment and financial counsel.
      • The company may be required to repurchase vested shares of departing employees. The funding of this repurchase must be managed carefully.
      • The equity value of existing owners is diluted any time a company assumes debt to finance a transaction without reducing the number of shares outstanding. This must be considered against the tax and other benefits an ESOP can provide.
      • ESOPs may not be appropriate for smaller companies because of their costs to establish and administer.

      These possible ESOP drawbacks should be carefully considered against the plan’s potential tax and other benefits.

      Neither Morgan Stanley nor its affiliates or employees provide tax, accounting or legal advice. You should consult your tax and accounting advisors on matters involving taxation, accounting and/or tax planning, and your attorneys with respect to legal matters. More specifically, neither Morgan Stanley nor its affiliates or employees provide any tax advice, tax guidance, or legal or tax opinions regarding the qualification of a particular security under Section 1042 of the Internal Revenue Code, nor do they prepare any forms necessary to successfully elect Section 1042 treatment. In every case, the client must consult and confirm with his/her tax and legal advisors whether a particular course of action meets the requirements of Section 1042, including whether a particular security is qualified replacement property and a particular purchase strategy meets the applicable time limits.

      Although Morgan Stanley offers both passive and active reinvestment strategies, its role is much more limited in the passive strategy. This is not a commitment to lend money. All loans are subject to required credit approval.


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