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June 24, 2018

Business Planning

The ESOP Option

Florida bucks the national trend in the number of business owners selling their companies to their employees.

Amy Welch Brill | 8/1/2004
John Pringle is proud that his name is synonymous with building residential communities in Lake County. Pringle Development, the company he started 23 years ago with his father, George, and wife, Mary, reached $47 million in revenue last year. This year, the company plans to sell 400 homes.

Like many business owners, Pringle had almost all of his net worth tied up in the company. About 10 years ago, when he began to look ahead toward retirement, Pringle started to think about how to cash in on his company's equity.

"Twenty years of rolling the dice on your net worth is a long time," he says.

Pringle explored selling the company. But he wasn't ready to completely hand over operations to a new owner, and he worried about what would happen to his employees. Through a financial planner, Pringle found an alternative: An Employee Stock Ownership Plan, or ESOP.

In June, Pringle, his wife and father sold their shares in the company to its 150-plus employees. The ESOP will allow Pringle to run the business until he retires "in about three to five years."

Pringle's move puts him midstream in a growing trend among business owners in the state.

Traditionally, Florida companies like Pringle's have been "underrepresented" in the ranks of ESOPs," says John Eckbert, principal at PCE Investment Bankers in Winter Park. But while the number of ESOPs nationally has remained stagnant throughout the last decade, the number of Florida companies opting for ESOPs has more than doubled since 1998 from 150 to about 360 today.

Financial experts say the reason more Florida business owners are setting up ESOPs could be simple: More business owners like Pringle may be learning of the option as they near retirement and look for a way to realize a financial gain from their years building their businesses. Many simply haven't been aware of how ESOPs work and their benefits, says Eckbert, who handled the ESOP for Pringle this year. "There's a great deal of ignorance about the product."

Owner advantages
Pringle's "leveraged" ESOP -- the most common type -- followed a classic ESOP structure.

First the company borrowed money from Colonial Bank to set up an ESOP trust. The trusts are administered by a trustee, who is usually a company employee or a financial expert hired by the company. Typically, the ESOP loans are guaranteed by either the company's revenue or the owner personally.

The ESOP trust then bought the stock from the Pringle shareholders, in this case John, Mary and George. A huge advantage for the Pringles from the ESOP approach came via that stock purchase: They deferred all capital gains tax from the sale, which they would have paid directly if they had sold the business to a third party.

The trust, meanwhile, will hold the stock in a "suspense" account as the company uses its revenue to make yearly contributions to the ESOP trust to pay off the loan. As the loan is paid off, shares of the stock are released from the suspense account and distributed to Pringle employees who work at least 800 hours a year.

The trust's board will hire an appraiser to place a valuation on the stock once a year. Employees may sell their stock back to the trust when they retire or leave the company -- for the price the board sets that year.

More tax advantages came to the Pringles after they switched their company from an S corporation to a C corporation. ESOP rules allow them to avoid capital gains taxes on the cash if the company is a C corporation, if the ESOP owns more than 30% of the company's shares and if the owners reinvest the cash in U.S. bonds or stocks within a year.

In addition, if the children of John and Mary inherit those investments, the children will avoid the capital gains taxes as well.

Pringle won't say how much he made off the sale to the ESOP, but he's definitely met his "financial objectives," he says. The value of a company selling to an ESOP is based on set indicators such as assets, multiples of revenue and what similar businesses have recently sold for.

Upside, downside
Because Pringle's ESOP is so recent, his employees have little idea how much the stock they own may be worth. But some ESOPs have generated some big nest eggs for workers.

Lakeland-based Publix has one of the oldest ESOPs in the country. While Congress didn't formally establish the ESOP mechanism until 1974, Publix founder George Jenkins originated a precursor in 1933 during the Great Depression, when he gave employees a $2-a-week raise to buy shares of stock in the company. That plan evolved into a 1974 ESOP that has produced an average annual return for Publix employees of about 17% a year.

"Cashiers and stock clerks have become millionaires through their Publix stock ownership," between contributions from the company to the ESOP and associates buying stock in the company's Employee Stock Purchase Plan, says Maria Rodamis, a Publix spokeswoman.

ESOPs don't always create millionaires, however. In 2002, hundreds of Enron employees lost retirement savings that had been tied up in stock through their employee benefit plans, including an ESOP.

Experts say the problem with Enron's ESOP was that it was structured in such a way that Enron's board essentially controlled the ESOP trustee, who is supposed to balance the company's interests with employees' interests.

Enron "brought to the forefront the conflicts that can result in an ESOP," says Sherwin Simmons, chairman of Steel Hector and Davis' tax group in Miami.

Dee Thomas, president of a physical therapy company in New Port Richey that became employee-owned in the early 1980s, was among those who lobbied Congress not to overreact to the failure of Enron's ESOP. "The fault is not the ESOP's, but selfish decisions by management." Congress didn't pass proposed regulations that would have restricted ESOP formation.

The payoff
It's unclear whether ESOP formation nationally will begin growing again. A new bill introduced in Congress this year that would eliminate the 10% penalty tax on the distribution of S corporation earnings passed on to the ESOP could inspire more companies like Pringle's to opt for the plan.

ESOPs aren't for every company -- particularly struggling firms. Karen Bonn, director of ESOPs at BDO Seidman in New York, warns that a company must have a steady stream of revenue to pay off the loan that funds the ESOP trust. "I have sat in meetings (with company owners) and said 'No ESOP for you,' " says Bonn.

Business owners who've lived with an ESOP for a while, however, tend to be fans. Thomas observes that after her business, Thomas and Ewing, formed its ESOP, her 22 employees began to care more about the company's goals. "Prior to the ESOP, there was not the same concern with all of the employees about the bottom line," she says.

Through an ESOP, Thomas and her partner were able to sell their shares in the business, keeping control of the company while realizing $750,000 on the sale.

"Here we still are after all these years. Why is that? Because of the ESOP," Thomas says.

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