What Offers Capital Creation, Employee Benefits and Untaxed Profits?


money-gift.jpgAn ESOP is a retirement plan designed to purchase the highest and best class of stock of a corporate plan sponsor with tax-deductible contributions and/or tax-deductible dividends from the company. The ESOP is indifferent to the source of the shares (i.e. shareholders or a new issuance). There are limits to how much a company can contribute to an ESOP annually and the shares must be independently established at fair market value. An S or C corporation bank or bank holding company can sponsor an ESOP.

Who Should and Who Should Not Create an ESOP?

The bank must have sufficient number of employees, adequate ongoing earnings and sound capital/leverage ratios. The bank must:

  • have at least 30 employees and sustainable annual pre-tax profits of $500,000 or more
  • be a viable, long-term going concern
  • make a market for shares (either new issues for capital or from outside shareholders) of $500,000 or more at some point, and be well capitalized, both for valuation and regulatory purposes (e.g. Tier 1 capital ratio of 10 percent or better)
  • be willing to support the complexity and cost of the plan (small stock plans can cost $20,000 annually to maintain due to requirements for annual independent valuations, record keeping and additional accounting)
  • have the ability to make annual plan contributions in stock or cash averaging $200,000 or more; some variability downward (even zero) in bad years is possible, but good years should offset that

One Example: An ESOP Benefits a Bank or Thrift

A single-bank holding company which had taken TARP is now profitable, making $2 million in pre-tax earnings as a C corporation with 200 shareholders and capitalization of $400 million. The board wants to improve key executive benefits, hopefully increase capital (to help with the retirement of the TARP obligation) and mitigate taxes.

By establishing an ESOP and pre-funding it with cash for two years ($500,000 annually) at a level which did not degrade capital ratios, there is $1 million in cash available to purchase new shares in a capital stock transaction.  The resulting $1 million  tax-free cash arrives on the balance sheet at the price of some shareholder dilution, but represents Tier 1 capital and a possible source of a partial TARP repayment. The effects are:

  • The company has $1 million of tax-deductions spread over two years.
  • The tax arbitrage (taking dollars to the balance sheet at dollar-for-dollar vs. 60 cents per dollar of taxable income) results in better capitalization.
  • The non-ESOP shareholders have some minor dilution with the purchase of newly issued shares.
  • The 57 employees eligible to participate in the plan do so irrespective of TARP—key executives with compensation above $100,000 received 43 percent of the allocations in the ESOP. (A non-qualified discriminatory key executive plan was out of the question with TARP, and even without TARP, would be non-deductible.)
  • The 8 percent ESOP is controlled by the trustees, appointed by the board.

Here are Five Key Do’s and Don’ts

1. Don’t install an ESOP just for a near-term tactical tax advantage—implement a coordinated strategy tying the ESOP market/benefits to key executive programs, capitalization, shareholder market needs and all the regulatory requirements.

2. When considering an ESOP, get a competent feasibility study done (at a cost of $10,000 to $25,000), even if the threshold criteria are all met – there may be something lurking in the weeds.

3. Be prepared to deal with complexity in the coordination of employee benefit law with the management of both cash and stock flows between the bank, shareholders and ESOP, with clear definitions of the roles of the board, trustees and supporting professionals.

4. Don’t consider the ESOP stock repurchase obligations something to be dealt with in a few years as the plan matures: analyze and understand the strategy for the funding and management early on.

5. Do engage and educate your ESOP participants in the benefits of the plan to loyal, long term employees.

Some Resources:

1. The National Center for Employee Ownership (www.nceo.org) is an excellent source of educational materials.

2. The ESOP Association in Washington, D.C., is an ESOP advocacy organization and has helpful publications (www.esopassociation.org).

3. A booklet expressly for bank boards considering the ESOP alternative is: “The ESOP Handbook for Banks: Exploring an Alternative for Liquidity and Capital While Maintaining Independence”, 83 pp, Peabody Publishing, 2011 (ISBN 978-0-9825364-4-5).

Using an ESOP to Raise Capital


Privately held community banks have had a tough time raising capital during the financial crisis and its aftermath. Investors are cautious and community banks have been especially challenged due to the economy’s troubles and investors’ desire for liquidity. One option for those banks is an Employee Stock Ownership Plan, or ESOP. Basically, an ESOP is a tax-qualified retirement plan that benefits all employees who meet certain criteria, such as 1,000 hours of service. An ESOP can use the tax deductible contributions made by a bank or bank holding company to purchase newly issued stock, thereby returning the cash to the balance sheet of the bank or holding company. These funds improve capital strength and could also be used to repay funds to the federal government’s Troubled Asset Relief Program. W. William Gust, J.D., L.L.M. of Corporate Capital Resources and Andrew Gibbs of Mercer Capital discuss some of the benefits of ESOPs and how they might help a bank raise capital.

How does it work?

The bank or bank holding company makes contributions to an ESOP, either in stock or cash, subject to certain limits. These contributions are allocated among participants in proportion to compensation or compensation plus length of service. An ESOP may use its cash to purchase newly issued shares or existing shares held by non-ESOP shareholders, as well as to purchase shares from participants exiting the plan.

What are the benefits of ESOPs for a bank?

Unlike retirement plans such as 401(k)s, ESOPs can purchase shares of the sponsoring S or C corporation. An ESOP can borrow money to purchase stock. Principal payments on the acquisition loan are tax-deductible. The ESOP is treated as a single, tax-exempt shareholder. S corporation ESOPs do not face the tax liability that otherwise would pass through to shareholders. As a hypothetical example, if the bank contributes $100 to the ESOP, it could save $40 in taxes and use the savings to purchase more bank stock, either to repay TARP or meet other capital raising goals. Because contributions are tax-deductible, purchasing newly issued shares is accretive to total equity, although the transaction would dilute the ownership interest of non-ESOP shareholders. While TARP requirements preclude key executives from non-qualified and discriminatory plans, they do not apply to ESOPs.

Why do banks make more use of ESOPs than companies in any other industrial classification?

Closely held banks often need a mechanism to acquire shares efficiently. An ESOP permits containment of the number of stockholders through an untaxed mechanism ultimately under the governance of the board. Most bank ESOPs are minority-interest owners.

What benefits do they have for participants?

The participants receive a retirement benefit as an equity interest in the sponsor at no cost to themselves. ESOPs typically reward loyal, long-term employees through vesting schedules, eligibility rules and the like, which cause the bulk of the plan assets to accumulate in their accounts.

In what instances would an ESOP not be appropriate?

ESOPs require a profitable sponsor, the ability to create value over time and a sufficient number of employees to meet the various compliance tests. Companies with fewer than about 25 employees or profits below about $500,000 (pre-tax, pre-ESOP) are not suitable, though there are exceptions. Since they have a market, widely traded public corporations do not often use ESOPs. Highly leveraged ESOPs often are inadvisable.

Who controls the stock?

The trustees are the legal owners who vote the stock for private corporations, except for major transactions. Participants in public company ESOPs vote all shares allocated to their accounts.

How is value established?

The trustee establishes value. For privately held banks, the trustee engages an independent appraiser to value the stock. Valuing banks in the current regulatory and economic environment is challenging; banking industry and ESOP expertise should be key considerations for the trustee in appraiser selection. Appraisers will consider numerous factors and apply specific valuation methods considered most appropriate. Draft regulations from the U.S. Department of Labor provide guidance specific to shares held by ESOPs.