Now, More Can Join The Esop Game

The privilege is extended to S-corporations--with the pitfalls

David Copham is one persistent man. For years, the owner of Liberty Check Printers had wanted to set up an employee stock ownership plan (ESOP) at his Mounds View (Minn.) company. Yet like many small businesses, $70 million Liberty was an S-corporation, where the owners pay taxes on earnings, but the company itself pays no corporate tax.

By law, S-corporations were barred from setting up ESOPs, as other small companies can do. But Copham fervently believed that employee ownership would be in everybody's best interest. Working closely with a group of like-minded advocates that coalesced around the S Corporation Assn., a Washington-based trade group, Copham made changing the law a virtual obsession. Finally, after three years of lobbying, Congress attached an S-corp ESOP provision to a 1996 small-business bill. Copham even briefly met Bill Clinton at the signing ceremony, where he got a quick chance to tell the President how important it was to encourage employees to become owners.

Victory was fleeting, though. An oversight in the bill's wording meant that S-corporations still couldn't start ESOPs. Copham didn't give up. "He just wasn't going to stop," says Robert Blair, a Washington lawyer and chairman of the S Corporation Assn. "It was his energy and persistence that kept things rolling." Finally, last year, Congress erased the remaining barriers, and on Jan. 1, Liberty became the first S-corporation to adopt an ESOP. The company's roughly 500 employees got their first shares in the first quarter and now own 5.47% of the company. Copham helped open a door for the country's other 2 million S-corporations to walk through.

ESOPs hit the big time during '80s deal mania, when large, publicly traded companies embraced them for their tax breaks and as a defense against hostile takeovers. With the demise of the raiders, however, stock options replaced ESOPs as public companies' favored mechanism for turning employees into owners. These days, more than two-thirds of all ESOPs are adopted by closely held companies.

Under the new law, S-corporations can finally join the game. Think of ESOPs as a kind of retirement plan with a host of tax advantages for owners and employees alike. The company makes annual contributions of stock to the ESOP. As with other benefit plans, taxes are deferred until employees start withdrawing their shares in retirement. The company gets to deduct its contributions to the ESOP. It also can deduct interest on any money that's borrowed to fund the plan, as well as dividend payments used to repay the loan. Even repayment of the principal is deductible.

S-corporations can get many of the same goodies now, with one major exception: Company owners can't defer taxes on the sale of their stock. Stockholders of other types of private companies can do so if their gain from the sale is rolled over into the equivalent of a pension plan.

One key advantage of ESOPs for small-business owners is that by selling to employees, owners have a ready market for their stock after it is assessed by an outside valuation service. "Many privately held and family-owned businesses would prefer to transfer ownership to employees rather than sell to a larger company or a foreign multinational," says Jared Kaplan, partner at the law firm McDermott, Will & Emery.

Smaller companies also see ESOPs as another benefit they can offer in a competitive labor market. Liberty has two employee pension plans, including a 401(k); the ESOP is one more lure. "It's hard to keep Generation-Xers," sighs Copham. "They just won't work for a paycheck anymore. They want an equity stake in something." Adds Corey Rosen, executive director of the National Center for Employee Ownership: "More and more owners believe they need to do ESOPs to retain and attract people."

NO MAGIC BULLET. Supporters argue that for companies, the promise of higher productivity after ESOPs can even outweigh the tax breaks. ESOPs can be especially effective when combined with employee participation in company decisions and when management shares financial information with employees. On average, such companies can expect to grow 6% to 11% faster with an ESOP than without one, says Rosen.

Still, "ESOPs aren't a magic bullet," cautions Joseph Blasi, a management professor at Rutgers University. When ESOPs are established just to milk the tax breaks--and employees aren't given a bigger say in day-to-day operations--companies often do worse than before, he and other experts warn. The reason: Employee expectations are dashed, and morale and productivity suffer, studies show. "Participation lets employees act like owners, and the information allows them to be responsible owners," says John Logue, head of the Northeast Ohio Center on Employee Ownership at Kent State University.

There are other downsides to ESOPs. They're complicated to set up and require a lot of outside professional services. The typical small business will shell out $25,000 to $40,000 to do all the things it takes to get an ESOP going. And workers wind up with a big chunk of their retirement money tied to the fortunes of one company. The risk is all the greater at a small company, whose survival is often more tenuous than a large, publicly traded giant's. Still, employees come out ahead if the alternative is no pension plan at all or one that's less generous than an ESOP--and small companies are less likely to have retirement plans than large ones.

ESOP enthusiasts often get carried away when they hail employee ownership as the vanguard of a "people's capitalism." But ESOPs do offer owners a good way to turn employees into shareholders. Now, owners of S-corporations have the option to join the party.

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