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Key Considerations in a Second-Stage ESOP Transaction

For a second-stage ESOP transaction, there can be a variety of transaction structuring alternatives. Read on for details on two common structures.
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According to the National Center for Employee Ownership (NCEO), there are now approximately 6,700 employee stock ownership plans (ESOPs) in the U.S. covering more than 14 million employees. Nearly 4,000 of these ESOPs are 100% ESOP owned. Although most ESOPs are 100% owned, many companies are structured as partially owned ESOPs for various reasons. These reasons could include an owner’s desire to retain majority ownership and control of the company, the company’s cash flow inability to cover debt service needed to effectuate a 100% transaction, or owners with different horizons for retirement. Whatever the reason, many business owners and companies may see a second-stage ESOP transaction as the next step in their succession planning strategy. When contemplating a second-stage ESOP transaction, there are a number of considerations, including transaction and internal loan structuring alternatives as well as fiduciary and valuation effects.

Transaction Structuring Options

There can be a variety of transaction structuring alternatives. However, two common structures for second-stage ESOP transactions include:

  1. Direct sale to ESOP of non-ESOP shares
  2. Company redemption of non-ESOP shares

Direct Sale Structure

Under the direct sale scenario, selling stockholders sell their stock directly to the ESOP. Under this structure, selling shareholders may be eligible to sell their stock in a tax-deferred or potentially tax-free transaction by making a Section 1042 (1042) gain deferral election if certain requirements are met. To take advantage of 1042, generally the company must be a C corporation at the time of the sale, the ESOP must own at least 30% of the employer stock after the sale, and the taxpayer must have held the securities for at least three years prior to the sale.

If 1042 is elected, the selling stockholder is required to reinvest in qualified replacement property (QRP) within 12 months of the sale date. QRP is essentially stocks or bonds of domestic operating companies. Mutual funds, municipal bonds, and certain other investments aren’t considered qualifying property. The tax basis in the company stock sold carries over to the QRP. The deferred gain is realized only when the QRP is sold. However, if the selling stockholder holds the QRP until death, the QRP will become part of the stockholder’s estate. At that time, generally the QRP will receive a step-up in basis (in years where the estate tax is in effect), thus permanently avoiding gain recognition related to the ESOP sale (under the current tax law).

Because the ESOP trustee is a party to the sale transaction, the ESOP trustee will perform due diligence and negotiate the sale price. Typically, there is a significant post-transaction drop in the stock value because the company has just taken on additional debt to fund the second-stage purchase, while the number of shares outstanding remains unchanged. This can have a temporary yet negative effect on the ESOP accounts of long-tenured participants and participants in equity-based deferred compensation plans. To protect these participants who may retire in the near term from the effect of this decline in share value, the company may consider adding price protection, i.e., a “floor value,” related to the previously held ESOP shares. Because the ESOP can’t pay more than fair value for a participant’s shares, the price protection would be accomplished through an agreement by the company to pay these participants based on a price that doesn’t consider the effect of the second-stage transaction indebtedness. The price protection generally would remain in place until the second-stage debt is repaid. While price protection is commonly used in second-stage ESOP transactions, there are a number of esoteric issues that need to be addressed; thus, it’s important to seek legal and tax advice prior to implementing.

If additional shares are purchased via an inside ESOP loan, these shares will be allocated to participants over a period of time. This structure can help address issues related to not having enough shares to allocate to new participants because of a concentration of shares in the accounts of longer-tenured employees, i.e., haves and have-nots. However, it’s important to perform adequate modeling based on facts and circumstances to determine the appropriate duration of the new internal loan. For example, shorter loan terms (10 to 20 years) are more common in second-stage transactions. Longer loan terms (20 to 40 years) are more common in majority ESOP transactions. The analysis should review the projected contribution rate (value of stock being allocated to participants on an annual basis divided by the total eligible compensation) to help ensure the benefits being provided to participants are meaningful while balancing the projected company cash flow needs to fund the ESOP repurchase obligation.

Company Redemption Structure

Under the company redemption scenario, selling shareholders aren’t able to elect 1042 because their shares are being redeemed by the company rather than being purchased by the ESOP. If the seller receives cash for their shares at closing, generally they will recognize capital gain at the time of the transaction, subject to federal and state long-term capital gain tax rates (assuming the stock is held for one year and one day). If the seller finances all or part of the purchase price, generally they have the option to take installment treatment, allowing the seller to pay the capital gains tax over a period of time as the seller note is repaid.

There’s generally no post-transaction drop in share value in a redemption transaction. Both the numerator, i.e., overall company value, and the denominator, i.e., outstanding number of shares, are both reduced in determining share value. The company value is reduced by the debt incurred and the number of shares redeemed, thus neutralizing the impact on the share value compared to an ESOP sale. However, since the number of outstanding shares is decreased, any appreciation in the equity value of the company may lead to more rapid stock price growth over time compared to a direct ESOP purchase.

With a company redemption, no additional shares of stock are acquired by the ESOP. This can potentially exacerbate the problem of haves and have-nots. The company could consider contributing shares to the ESOP from treasury over a period of time to increase employee benefits and make shares available to new participants.

Fiduciary & Valuation Considerations

ESOP trustees have a fiduciary responsibility under the Employee Retirement Income Security Act of 1974 (ERISA) to act in the best interests of the ESOP participants. They must consider whether the transaction is prudent and if the proposed transaction meets the exemption of the prohibited transaction rules under ERISA. The ESOP trustee is prohibited from paying more than fair market value for shares acquired both directly and indirectly by the ESOP. The ESOP trustee will engage valuation and legal advisors to help evaluate the prudence of the proposed transaction and receive formal, written opinions from these advisors.


As you can see, it’s important to carefully consider the structure of a second-stage ESOP transaction. A second-stage transaction can be more complex and more time-consuming than the original ESOP transaction. To learn more, please reach out to a professional at Forvis Mazars or submit the Contact Us form below.


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