EP37 - The Gift of an ESOP

In this holiday episode, Jason and Makenzie explore the ESOP as a meaningful gift to a company’s employees. They break down how ESOP benefits work for both owners and employees and unpack the mechanics behind inside notes versus outside notes. This episode is a helpful resource in understanding ESOP verbiage and the real benefits that employees receive through a company transitioning to an ESOP. 

Transcript

[0:13] Thank you and welcome back to the journey to an ESOP and Beyond podcast where we seek to make all things related to Employee Stock ownership plans both accessible and understandableI'm your co-host Today Jason Miller. And I'm McKenzie worthand we are going to talk about gifts today uh and most specifically how esops uh are a gift or how some people consider the the ESOP a gift to their employees and what are the implications of that and what are the mechanics how does it how does it really work uh and obviously we are uh at the time of this recording very close to the holidays kind of in the middle of of the holiday seasonum. And for for those of you listening and not watching um you might want to go to YouTube and see that I'm I'm wearing a a Christmas themed t-shirt uh that's a a Marvel Christmas shirt, got Heroes dressed up in in Christmas gear and it says gifted at the top, um so we're going to dig into that a little bit today and and talk about my uh my wardrobe uh as well as as esops what do you think McKenzie ohyesterday when I was wearing my ugly.

[1:35] I did miss out on that so I'm just just trying to to live a day in the future or a day in the past I guess is a better way to look at itum. I had a client a number of probably a number of years ago now that said hey I I noticed a trend in your your T-shirt collection Jason you've got 3 different types of t-shirts you've got Christmas t-shirts, you've got superhero t-shirts and then you have sarcasm t-shirts um and the more I thought about that the more real it it really is uh and then some of them happen to overlap so I could do a VIN diagram of superhero t-shirts Christmas t-shirts and sarcasm t-shirts. I like it I feel like it's very fitting for you Jason you don't say you don't sayumsoon thatthat that topic of.

[2:34] How to view the ESOP transaction toward the employees not necessarily from their shoes but but toward themand, Founders and selling shareholders are going through a transaction we talk about that they're exchanging uh you know the the value of their company for financial instruments and for for cash of of equivalent value um and it's this this really. The Arcane kind of. Uh arrangement of all all of those different piecesuh and we talk about the buyer as as the ESOP, uh and then we talk about or the esot I guess we should be very specific today so the Employee Stock ownership trust is is the buyeruh as the the foundation of that and then the Employee Stock ownership plan the retirement plan aspect is what brings them mechanics. Uh in between the trust and the company and not between the company and the selling shareholders.

[3:43] Right and I think that's something that'sunderstandably a veryconfusingNuance of. Of the transaction it's often referred to as. The inside note and I think it can often be mistaken forreal debt.

[4:06] Which I know is something we'll we'll peel back a little more here.

[4:11] McKenzie do you want to go through um so you mentioned inside note I've I've said in in inside note um and we've articulated the the trust, and the company and the selling shareholders uh if you'd walk us through the the material differences uh at a high level of why it's called an inside note and what what the opposite of that is, yeah so an inside note means it is a note between the company and the ESOP Trust. Inside because I guess it's it stays within its within the company that the ESOP trust is obviously related to the company and then you have the company so it's it's. An inside notethis is different than an outside note which is between the company and. A third-party such as a senior lender or the selling shareholder.

[5:16] Back in the day um that they used to call it a mirror loan, um because the inside note uh mirrored the some elements of the outside notes um and then that that wasn't a a 1 for 1 kind of equation uh because considering things like basis uh and other adjustments and and whatnot between, the the different parties in our our transaction um the the inside note kind of became the prevailing vernacular around that that mechanic, so from the selling shareholders point of view uh again they've sold their stock to the trusts for the benefit of of their of their employees. Uh and in that for the benefit of their employees comes the the language that we hear a lot around esops in relation to those employees which is this is a a gift. To them. Um so do do they get all the stock at at the time of transaction like why does the inside note exist um and why does it need mechanics.

[6:33] Great questions um sothe inside note I I kind of start with why it existsso in an ESOP. Transaction when you're selling show whoa selling shareholder is exchanging their equity for debt. You mentioned they they are sellingtheir shares to the trust. However this trust is created it wasn't it didn't exist before it's solely created for the purpose of the transaction. So it hasnothing to repaythe selling shareholder that just sold its stock to the trust. So because of that the companyis going to pay the selling shareholderback on behalf of the trust. So the company's cash flows are repaying the seller.

[7:30] Since the company is doing this now there is this as we mentioned inside note between the trust and the company. So the trust now owes the company money instead of owing the seller money the selling shareholder.

[7:48] Power since it still has nomoney or anything to repay the company it needs a way to.

[7:58] Obtain cash to repay this inside note.

[8:04] Since it has this debtit's a leveraged ESOP by having an inside note.

[8:13] The shares that were sold to the trust arecollateral for this debt so they're held in suspense.

[8:23] The scenes that the shares. Do not get allocated to participating employees immediatelythey get allocated as this inside note is paid down. So B basically the the trust bought this gift on layaway. Right like for for for the season um and they're not entitled to ownership until all all of that obligation is is repaid, and it happens a little bit at a time as payments are made there's like weekly payments or monthly payments or quarterly payments. They are annual paymentswhich is dictated bythe note agreement. The actual formal legal document that like any other credit agreement no agreement there is 1 for the inside note.

[9:23] Got itand. I I deliberately use the word obligation because we needed another thing to confuse people about esops with uh as we're walking through the mechanics of of the inside note so in in that I I've always called it an IOU, um between the trust and the companyum, even though it is a loan it is it is documented as a loan it has an interest rate it's got an amortization table it takes place over a long period of time um. But it's it helps to articulate the the feel of it and you'd mentioned early on not not being real debt it looks like debt it smells like debt someone owes something to someone else there's collateral there's a payment schedule there's there's all all of this that that's wrapped in thereum. But it's more of more like an IOU thank you for buying these shares for me um for for the trust for the the employees um I I owe you what what you paid for it. Um and to your point but I don't have as a trust document I don't have any money not making any revenues you use the term payments and in a loan in real debt there are payments um but functionally really what what are those payments what are the the the 2 2 different descriptors for that.

[10:47] Uh annual contributions is 1 way to get cash into the trust right and then the other would be, distributions distributions very good testing you a little bit there just just for fun umand those are mechanisms that are 1 is available to every, every shareholder. Right so as as a shareholder as an individual shareholder I would be entitled to distributions of prophetsince the trust is a shareholder uh you can elect to make distributions um, and you to to the trust but that contribution piece is is unique to the the ESOP because the ESOP is a defined contribution retirement plan. So it it opens up this new Avenue of I'm allowed to make a contribution to the plan through the plan to the trust but the trust has this IOU it has this obligation it has this inside note that it has to repay, and so the contribution is 1 mechanism to get cash into the trust and then what is the trust do with those those funds.

[12:07] The trust uses those funds and sends it right back to the companyto satisfy the IOU or the inside noteobligation.

[12:18] And what does that trigger.

[12:21] So as as mentioned before the shares are collateral for this inside note so as the inside note gets paid downShares are released from suspense. To participating employeesretirement account. So a gift that's Le less like 1 on layaway and more like a multi-year Advent calendar exactly1 thing Iwantedbring the annual contribution. And a leveraged ESOP in the actualESOP plan documentit specifically calls out that the company. Must makeannual contributions to the trust in an amount that will satisfy.

[13:11] Theinside note paymentbased on the inside notes amortization schedule so mandated those are are equal installments um I thought I was being clever with my Advent calendar um but it it kind of works out for a couple of different reasons so if you think about some of those that you might find in the store during this season there's like little Lego Minifigures and some of them um there's chocolate or some other type of hard candy and you you sit down with your family maybe uh for for those that that celebrate Christmas at least um and and walk through like each day there's something to to have a family moment around and then there's 1 1 piece of of candy for everyone but it's the same. Uh over the course of those you know those days in the Advent calendarum and inside notes for transactions have a a lengthy typically have a very lengthy amortization schedule or a number of years that uh that are in play and we're thinking 20 25 30.

[14:19] 50 60 70 years depending on the uh structure and the parameters of each individual deal. The I think a lot of Founders when they hear that immediately think if we go back to mirror Alone um that they're not going to get repaid for 2025 3050 or 60 years right.

[14:44] And this is where those Concepts diverge and the inside note does not mirror, the outside leverage of the company to the shareholders or to the bank um those I I think that's why uh the the inside note vernacular survived over mirror loan yeah just speculating, yeah I think that it makes a lot more sense because I can see the mirror makes it.

[15:09] Confusing in thatit implies that more is in common than. There really is but in reality the the only thing that has to be in common between the inside note and the outside note.

[15:23] Isthe purchase price of the stock. Excluding anyany other notes that are issued to the sellers for example for distribution of their basis.

[15:46] Why there's a lot of confusion um why there's a lot of questions why it takes a while to absorb and and understand um and and really grasp it uh even as a a very savvy, business owner and founder and leader that's entertaining and ESOP transaction when we hearthe the. Umthe. When we hear the verbiage of inside note outside note and contributions and distributions and uh the plan and the trust and the obligation and the IOU and all all of that um it gets aum a little daunting I think. For sure it's very convoluted I know it took me a while to graspI'm still trying. Umso when we think, uh a little bit further about the uh like the metaphor of the Advent calendar and kind of equal installments uh you know if if a a parent wanted to give their their family their children more than what was baked in the Advent calendar they could, um right so you said they have to make the minimum contribution each year to service the the inside note IOU payment um. But could they do more.

[17:15] You can do morehowever you are well I guess specifically if we're we're speaking in in contributions. You can contribute More Than This minimum payment that's. Dictated by the amortization of the inside note but your subject to limitations.

[17:36] As prescribed by the IRSso it's. Called 404 section 404 limit where you cannot the amount that you're contributing cannot exceed 25% of payroll. So the IRS does not like uh increasing tax deductible, methods Beyond a certain limit you're saying that they're they have a tolerance for uh for tax deductions believe it or not, so that's going to lead some people to ask well I thought that an escort ESOP uh was tax exempt so what does it matter.

[18:23] Kind of throw me a car fall there that's a good point, so so let's reason through that for a second and that this is where specificity in, structure and language and intent all aligned and so 100% S Corp ESOP uh obviously is is not subject to federal and state income taxes most state income taxesum. And so the profits of the company are not going to create or they don't trigger a tax liability right. But the mechanics of, ownership are or I guess the the the qualities of of that ownership that tax exemption resides at the shareholder levelbut the IRS has to treat all companies the same so whether it's a pass through company or not, right and then we are making the assumption that all esops are 100% S Corp bone but, we know that that's not true so what what circumstances are different than 100% uh.

[19:36] Escort Esau escort yeah so if it's if it's a if it's less than 100% then you obviously have another shareholder that's not the ESOP. And underthe escorp scenario that that shareholderwell I guess regardless umyou have that. Contribution the contribution is tax deductible so it reduces the tax liability for that shareholder that is not the ESOP that. Not tax exempt like the ESOP is.

[20:11] And then we still have under s Corps the pro rata distribution uh qualifier as well, right so what 1 share holder gets the other shareholder has other shareholders have to receive in uh in accordance with with their ownership that same same distribution.

[20:32] So we have we're implying and are listeners some of you may be joining us for the first time this may be the first thing that you're hearing about esops is all all of this complexity that we we seek to help you understand uh a little bit better we don't want you to get um you know frightened at at this juncture for certain um but you might be hearing for the first time that wait, we we don't have to sell 100% of the company to the ESOP as we're thinking about transactionsand the answer to that is no you don't. Uh and we often tell clients thatnot only do you are are you restricted in selling 100% of your company like you don't have to do that but if you decided to sell a portion of your company to an ESOP. You don't have to finish that like it's not a once you're on the path you have to continue until the ESOP is the only owner.

[21:27] And many people uh aren't aware of the flexibility of this as a. A Glide path to an exit as my old friend Kevin used to say um and or its flexibility just in general and de-risking a personal balance sheet we use I want to say you know jargon phrases like that but really that's what's happening if your wealth as an individual is concentrated in your company as most Founders wealth is at certain stages um it's a great Tool uh to allow for for you to to to do that and look at a at a partial sale um all of what we've talked about today still applies in in a partial sale and then 1 Thing Mackenzie talked about this the CCP structure and how that that might be materially different.

[22:18] Yeah so under a cc Corp structure. The fact that you that your annual contribution to the ESOP trust is tax deductible. Remains the Samebut theportion that is owned by the ESOP is not tax exempt under a corpse structure. And specifically because it's not a pass through entity as a C Corp structure right right um and then, we're probably going to have to do an update, uh on on 1042 uh and do do a whole episode on that but uh C Core selling shares of a a CCP to an ESOP um at least 30%could qualify selling shareholders for the ability to defer their capital gains on the proceeds of that, that particular transaction, so now you're like Jason you threw in structure and CC Corps and S Corps partials and Fs and we were already talking about the inside note.

[23:26] So what let's go back to. The the gift portion of of this and really anchor your thinking around the the in the mechanics of the inside note are based on the ownership of the trust, and then the establishment of the plan. That allows the mechanism and the mechanism is detailed in the terms of the inside note. So we have owner we have mechanism and then we have termsand. If you do it things are finite right so if we go back to the Advent calendar and if we think about contributing more we have the limitation the IRS says you know you should you should keep it within this this range uh and that range is the 404 limitation of what they allow for a deductible expense via contribution through the retirement plan but distributions are really limited by the amount of of profit that that the company has uh and so distributions aren't aren't cappedbecause they're not, necessarily tax deductible in in any any way shape or form that we need to talk about today.

[24:39] Um but in the Advent calendar it's like the the ESOP note itself is determined at the time of transaction but esops are sustainable and their long-term and you know they're they're out there for a long time and we mentioned 2030 40 50 60 years it's like borrowing from the back end of the Advent calendar, uh and saying Here's 2 pieces of of candy or 2 toys today um but the more that we push to retire the inside note. Kind of the more we're borrowing from in the future and what we're what what we're borrowing there are the shares that are unallocatedand we're giving them to the people that are present on on this day. Mhm.

[25:25] So while it may feel generous and it may look generous to do more earlierthat the terms of that inside note and the mechanism that uh, that allows for all the magic to happen kind of front loads the magic leaving us where in half the time.

[25:50] In a place where you run out of sharesto allocate tonew employees that join your companyI think that's that's probably well, it's twofold but that's 1 that's part of. The biggest reason you don't want to allocate all of your shares immediately or accelerate the inside note. So that you won't have shares left over to allocate to new employees that join your company because you can't rely on the recycling of shares. From 1 people are retiring or or terminated involuntary voluntarily whichever way because you can't.

[26:34] Accuratelyestimate the timing of all of thatumbut then also your accelerating. And there I dare I say we get into the repurchase obligation here's an obligation word again um and now for those of you that are hearing about this for the first time you're like oh that's why you said that we'll add some confusion. Umand yeah you're you're right so it it's the the people that the family that's there in the beginning and your employees may feel like family and you do want to gift them with something good and well and write uh in and outsized way and you may want to pull forward shares by making a a higher contribution than what's. Minimally necessaryunder the terms of the notes but that has implications.

[27:26] So when we say structure and we apply the word structure to again a foundation of the trust the mechanism of the retirement plan and the terms of the note that's that's kind of an ecosystem that's a structure that that shouldn't be. Um shouldn't be messed with it's like taking out a load-bearing wall in your house if you're you're doing some construction probably not a thing you want to do without other supports um. And as you're doing the demo on your house to expand it uh you may find taking out that load-bearing wall is going to create more of a disaster. Uh than than a benefit and that's what we alluded to in the beginning like where could this go wrong like how could it possibly go wrong once it's established, this is how it could possibly go wrong and wrong probably isn't the right word uh you used um. I think you described it really well you have to be careful um and there are implications of the decisions that are made outside of the structure. And that can include making a greater contribution uh there's an implication to that yes what is it there may not be shares for people in the future.

[28:41] And that mental shift from.

[28:45] I want my employees that have been with me and I want the employees that are here nowto receive a benefit, and I I'm feeling generous or we're feeling generousto shifting to a a generational type view of the future employees that you don't know, that you can't conceive of at at at this point in time that may not even be born yet, but the intention in managing and stewardingthese the structure of these these mechanics is going to benefit those future generations and in realityrestraint. Within the structure also benefits the existing employees and the family that you have today. Because of that repurchase obligation that you're mentioning someone's got to buy back that promise someone has to buy back that those sharesfrom the the existing participantsand in buying them back you want to make sure as a a good Steward of of your company and your company's future, that you're not front waiting it so that you run out of candy halfway through the month and there's less of a reason for the family to gather around uh before the holiday does that make sensefor sure and I think that's I think that's a perfect analogy to describe it um.

[30:11] And I think that'sthat's something that's. Not discussed as much during thetransaction process given it's something that, that shows up later down the road and it's not really required you know you can't really assess anything at the time of transaction but it's encouraged or highly encouragedwithin the first few years I would say, I think we've said like 4 to 5 to have that repurchase obligation study so that your content constantly monitoring what that is um and. If it's.

[30:51] If it's increasing then you can say okay we've we've contributed too much to the ESOP let'sstick to the minimum or. Kind of adjust and plan accordingly.

[31:03] What what ifwe had developed a a 60-day advent calendar.

[31:16] How how. What what what could you do there with with that right like that that's starting before Thanksgiving and really functionally starting before Halloween much like Home Depot and Walmart do with. Putting their their Christmas decorations out a couple months early all rightum and it's kind of like Christmas fatigue uh in thinking about oh we're gonna. And if you apply this to the inside note and you think 60 years like that's such a long time um and why. And we won't get into the specifics but just just conceptually why would I ever do that if I don't want to start celebrating until after Thanksgiving.

[31:58] And my my answer to you would be in light of what we just shared and being measured and being deliberate and honoring the structure because that honors the future of the company that you're you're transitioning over to your employees that benefits them today benefits the the future employees. And all of thatwhat what you could do if you bought a 60-day Advent calendar is just wait until after Thanksgiving and then hand out to.

[32:25] Rightand and still kind ofend or finish on on time but if I only did it 3 Day Advent calendar. Um and it were like giant chocolate Santas um and and wise men or something like write 1 for each of the wise men it's just a a 15 pound wise man each day that gets gets handed overum, h h.

[32:54] That that kind of gives the wrong impression about not just the season um or what you want to communicate because what what happens then on on day 4. Someone's going to be sick first and then after that they're going to say where's my 15 pound camel write my chocolate camel um what what what's nextuh or it's going to create some measure of jealousy from those that start after day 4 and go where is mine, um because everyone is celebrating their statements from the last 3 years Where You released all the shares umbut I didn't get any I I open up my Christmas present um in those later years and there's nothing there for me.

[33:46] Yeah and I think the perfectlyhighlights the.

[33:52] I I don't know if I'd say risk but I guess kind of risks or did the downfalls and and. Everything we're discussing hereso listeners when you think about. The mechanics of the ESOP and the inside note.

[34:13] You this episode is going to haunt you because of how terrible the metaphors were and giant chocolate SAS and wise men um but every time that you hear that an ESOP is a gift to the employees gifts come with being a responsible Giverand. Giving the right care and attention to how that gift is delivered and over what time period the benefit of that gift isand then still being responsible for that gift like for at the risk of 1 more terrible Christmas metaphor uh it's like giving a Red Ryder BB gunright. And someone's shooting their eye out um and that that may not have been a responsible gift um sothe all all understanding all the mechanics park it and just think about who who do I want to benefit from this and understand that that goes into the proper structuring and then the understanding of its going to happen over time and we should be honoring that that structure so that everyone has the gift that you intended from the work that they've put in for you and alongside you and with you uh and that you've put in for them.

[35:34] So with that um we wish you a very happy holiday season we are grateful that you are continuing to listen or joining us for the first time or rejoining us after the last 1 um we're really glad you're here we would love to hear from you so reach out to us at journey to an esop.com and we will see you next week on journey to an ESOP and Beyond podcast, thank you thank you.