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8:00pm EDT April 25, 2008

Employee stock ownership plans, or ESOPs, are the most common form of employee ownership in the country.

Originating more than 80 years ago, ESOPs were first recognized by the government in 1974. Now thousands of companies have these plans covering millions of employees.

Among other things, ESOPs can be used to provide shareholder liquidity, to motivate and reward employees, and as an attractive form of debt financing. “There are many ways a company can benefit from an ESOP,” says Michael Savoy, managing director of Gumbiner Savett Inc.

Smart Business spoke with Savoy about ESOPs, how they have evolved and the benefits they provide.

How have ESOPs evolved over the years?

Employee stock ownership plans have been around since 1916 when Sears Roebuck decided to fund its pension plan primarily with company stock. The basic concept was that the employees’ ownership of Sears stock was not only a good retirement benefit, but was also an excellent way to motivate employees to improve the company’s profitability and, thus, the value of what they owned. In the early 1970s, the concept caught the eye of Senator Russell Long of Louisiana, who was the chairman of the Senate Finance Committee, and the whole idea gained momentum within the government. In 1974, with the help of Senator Long, the concept of employee ownership was formally recognized by the federal government. Since then, a series of tax laws has been enhanced and modified to provide tax incentives that encourage employee ownership.

How can a company benefit from the establishment of an ESOP?

Firstly, a business owner can, under certain circumstances, sell his or her shares to an ESOP and either defer or, in some cases, completely avoid paying taxes. Companies can also make tax-deductible contributions to ESOPs, which results in a tax shield that creates value. Employees who purchase all or part of a company through an ESOP have a unique opportunity to build wealth via the underlying stock appreciation without assuming any personal liability. Finally, one of the most important benefits that companies can realize from the establishment of an ESOP is what I call the productivity benefit. Published studies have shown that companies report significant productivity improvements after establishing an ESOP.

In what ways can ESOPs spur employee motivation?

If employees own a piece of the business, they do things differently than if they are just employees. At an ESOP seminar I attended, a CEO related a story about a receptionist that now owns a piece of her company. The receptionist was put in charge of purchasing office supplies. All of a sudden, she started taking bids and shopping around for the best prices. This resulted in the company saving tens of thousands of dollars. This is just one aspect of productivity improvement, and it illustrates how people at all levels take pride in ownership.

How do ESOPs create a shareholder liquidity alternative?

Most business owners today have the majority of their personal net worth tied up in their business. Through the use of an ESOP, they are able to sell some, or all, of their company to employees. They can still maintain control of their company and, thus, diversify their assets while in most cases paying absolutely no taxes on the transaction.

What is the difference between a nonlever-aged ESOP and a leveraged ESOP?

The difference is that no borrowing takes place with a nonleveraged ESOP while borrowing takes place with a leveraged ESOP. A nonleveraged ESOP is similar to other tax-qualified pension or profit-sharing plans. A company can make annual tax-deductible contributions, generally limited to 15 percent of employee salary, to an ESOP in the form of cash or stock in the company. If you donate additional shares of stock to an ESOP, not only is the company getting a tax deduction for the value of those shares, but there is no cash coming out of the company.

In a leveraged ESOP, the company borrows money, either through the shareholder or a third party, such as a bank, to repur-chase shares from the existing shareholder. In the case of a leveraged ESOP, the limit for annual tax-deductible contributions is 25 percent of employee salary. An additional benefit is that payments of both principle and interest are tax deductible.

How do ESOPs create value?

Aside from the potential productivity improvements, there are also many economic benefits. As we discussed earlier, with nonleveraged ESOPs, if you donate shares of stock, your company is making no cash contributions and, thus, tax savings are realized simply through the issuance of additional shares of stock.

For instance, if a $1 million dollar contribution were made in the form of stock, a company with the 40 percent corporate tax rate would be saving $400,000 in taxes and there would be a $400,000 cash flow improvement. There is no other type of vehicle that allows this type of transaction.

MICHAEL SAVOY is managing director of Gumbiner Savett Inc. Reach him at (310) 828-9798 or msavoy@gscpa.com.