Employee Stock Ownership Plans, or ESOPs, are gaining tremendous momentum as a tax-advantaged way for business owners to divest some or all their stakes due to various factors, such as demographics, the employee ownership provisions of the Worker Ownership and Readiness and Knowledge Act (WORK Act) found in the SECURE 2.0 Act, and states’ efforts to promote employee ownership. Through IRC 1042, a business owner can sell all or part of their business interest to an ESOP, allowing them to indefinitely defer and eliminate the capital gains taxes typically associated with selling a business. Additionally, profits of a 100 percent ESOP-owned company become tax-exempt. The tax savings are redirected to repay the debt incurred to acquire the sellers’ company. Sellers receive the full fair market value for the company, retain leadership positions including board control, and can pass the reins to family members or other designees when they are ready. With these significant benefits come numerous opportunities for utilizing life insurance. This article explores some of the various ways in which life insurance can be deployed in this context.
Case Study
Archer, Inc. is a leading manufacturer of left-handed smoke shifters with 125 employees and annual revenue of $60M. Business value is $72M. Archer, Inc. is owned by D.M. Archer and A.G. Archer who are 62 and 61 respectively with a total net worth of $100M.
Key Person
Successful companies rely on key employees to drive revenue and profitability. The loss of a key employee would potentially hinder the cash flow of the company and the ability to pay back the debt incurred to buy the shares from the selling shareholders. A cash infusion from the proceeds of Key Person life insurance could substantially mitigate the effect of the potential loss of cash flow that may occur with the loss of a key individual until a suitable replacement can be made.
Risk: Archer, Inc. has three key individuals that account for 50 percent of Archer, Inc.’s annual revenue. A loss of any one of these three would have a significant negative impact on Archer, Inc.’s revenue. Archer, Inc.’s management believes that it will take about three years to identify, hire and train a replacement to the point where revenue is back to pre-loss level.
Solution: Archer, Inc. purchased Key Person life insurance policies on each of the three key employees for 20M each, the amount estimated to replace the lost revenue for each key employee over three years.
Debt Cancellation
Generally, in a 100 percent sale to an ESOP, the transaction is financed with a combination of bank and sellers’ installment note debt. Sellers usually remain in active roles to drive revenue that is used to pay off both the bank and sellers’ debt. The death of a seller may cause a significant disruption to business operations and make it difficult to make the required debt payments to the bank and the seller’s heirs. Life insurance on the sellers can instantly pay off the debt to the bank and the sellers’ heirs to prevent the company from detrimental effects of defaulting on its contractual debt payments.
Risk: The unfortunate premature death of D.M. Archer would heavily strain Archer, Inc.’s ability to pay the required debt payments to the bank. The bank may seize corporate assets that were used as collateral upon default on the bank loan. The loss of business assets may make it even more difficult to pay D.M. Archer and A.G. Archer’s heirs, the seller notes payments that were scheduled to be paid to D.M. Archer. The result of a default on the seller note payments is that D.M. Archer’s heirs would receive company stock in lieu of the seller debt payments that may be worthless.
Solution: Archer, Inc. purchased $68M in life insurance on the life of D.M. Archer which is the amount of the combined bank and seller debt (assumed $4M of corporate cash was used in the transaction). At D.M. Archer’s death, all transaction debt is immediately extinguished allowing the company to begin to resume operations and D.M. Archer’s heirs to be made whole.
Partial Sale Stock Purchase
Stock sales to an ESOP may be 100 percent of the company stock or less than 100 percent depending on cash flow, goals and objectives of the sellers. Generally, it may be difficult to sell a partial interest of a business especially if the remaining portion is less than a majority interest. It may be even more difficult to sell an interest upon the death of a non-ESOP shareholder who may be a significant influence on the success of the business.
Risk: D.M. Archer decided to sell 51 percent of his interest in Archer, Inc. to its ESOP to not only take some chips off the table and avoid a minority sale discount but also to capture a potential significant uptick in stock value for the future sale of the remaining 49 percent. D.M. Archer is concerned that if he dies prior to the sale of the remaining 49 percent that the potential value increase may not materialize and that the remaining 49 percent may suffer a value decrease in his absence.
Solution: Archer, Inc. purchased a life insurance policy on D.M. Archer in the amount of $40M which is the anticipated future value of the D.M. Archer’s remaining 49 percent interest. Upon a premature death of D.M. Archer, the company would use the $40M death benefit to purchase D.M. Archer’s remaining 49 percent interest from his estate via the terms of the buy-sell agreement making D.M. Archer’s family “whole.”
Repurchase Obligation
The company sponsoring an ESOP must “make a market” for vested plan participants who are entitled to receive distributions from the ESOP once participants cease employment. This “Repurchase Liability” is a federally mandated required stock buy-back provision for non-public ESOP companies. IRC section §409(h) provides a “put option” enabling participants to sell shares back to the company. The ESOP Trust, rather than the sponsoring employer, may purchase the stock back from the participant if it so chooses, however the obligation ultimately rests with the company.
A set of corporate owned life insurance policies (COLI) policies may be purchased on the highest paid employees who will most likely have the largest ESOP account share values. The policies’ accumulated cash values may be withdrawn/borrowed as needed to meet the company’s stock buy-back in any given year. The policies’ death benefits can mitigate the buy-back requirements of large ESOP account balances of higher paid employees. Policies may be aggregately funded to provide cash values and death benefits to cover the repurchase obligation of the entire employee group.
Risk: Archer, Inc. obtained a repurchase obligation study (RLS) from their ESOP consultant that shows the annual out-of-pocket cash outlay that is projected to be needed annually to buy back the shares from exiting plan participants. Archer, Inc.’s Board and senior management realizes that cash flow can handle the liability in the early years but are concerned that as the liability grows past year 10, cash flow will not nearly cover the liability. Management is also rightfully concerned that if employees learn that there might not be enough money in the later years, they might quit while there are still funds on the balance sheet. The Board of Directors has also learned that they may be held liable for breach of their fiduciary duty for not adequately managing the company’s ESOP repurchase obligation.
Solution: Archer, Inc. purchased a set of 35 corporate owned life insurance policies on the top 30 percent wage earners at Archer, Inc. for $2M each. The policies are corporate owned with Archer, Inc. as the premium-payor and beneficiary. The policies are projected to build significant cash surrender values for the company to use as a supplement to cash flow as needed to meet annual repurchase obligations. Additionally, the policies have significant death benefits payable at death of the 35 insureds. The death benefits flow into the company tax-free to replenish the corporate coffers so that Archer, Inc. can more readily meet its future repurchase obligations. (Pro Tip: Archer, Inc.’s life insurance agent negotiated a guaranteed issue arrangement with the insurance carrier that made the issuance of the 35 policies a much less burdensome process for the company and insureds. The guaranteed issue program also allows for the addition of new policies on executives as they meet the guaranteed issue criteria.)
Stock Appreciation Right (SARs)/NQDC Liability
It is very important in an ESOP transaction that key executives of the company continue to perform at a high level to ensure the company’s ability to pay back debt incurred to purchase the seller(s) stock. Additionally, the sellers’ sale price is likely enhanced when top executives are tied into the company with employment agreements and “golden handcuffs” such as a traditional nonqualified plan or Stock Appreciation Right (SARs) that are more common in the ESOP scenario. Regardless of the form of executive benefit, a future corporate liability is created and should be informally pre-funded so that the company has the cash available when the promised benefit is due.
Risk: Archer, Inc. has three key individuals that account for 50 percent of Archer, Inc.’s annual revenue. The departure of any one of these three would have a significant negative impact on Archer, Inc.’s revenue. Archer, Inc.’s management believes that it will take about three years to identify, hire and train a replacement to the point where revenue is back to pre-departure level.
Solution: Archer, Inc. implemented a Stock Appreciation Rights (SARs) plan for the three key executives that will hopefully be a strong incentive for them to stay and drive stock value growth. Each of the three executives were granted “synthetic shares” of the company and are paid in predetermined intervals based on the growth/appreciation of Archer, Inc. stock during each interval. The SARs plan creates a liability on Archer, Inc.’s balance sheet that should be informally pre-funded to ensure adequate funds are available when the scheduled SARs payments are due to the three executives. The estimated total SARs payout to the three executives over the next twenty years is $5.5M. Therefore, Archer, Inc. purchased three life insurance policies each with combined targeted cash surrender values of $3M that can be used to supplement cash flow to cover the SARs payments when due and recover the cost of the premium and payments with the eventual death benefits that will be paid to Archer, Inc.
Warrant Obligation
It is very common in a 100 percent ESOP transaction that the sellers receive a portion of the sale proceeds in cash from a senior lender and a portion paid over a period of years as sellers’ installment payments. The sellers’ installment payments are subordinated to the senior lender with an interest rate below what a subordinated lender would require. Therefore, sellers deserve a “premium” for their subordinated, below market rate position. Typically, the premium is in the form of warrants or the value of a future equity stake of the company once all the original transaction debt has been paid. Generally, a cash payment of 15-20 percent of the then-current value of the company is paid to the sellers as the reward for bearing the subordinated position. The future warrant payment creates an additional liability on the corporate books which should be properly funded through a sinking fund to offset this corporate liability.
Risk: The projected warrant value owed to D.M. Archer is an additional $19.4M payable in 10 years. The additional cash that is owed to D.M. Archer poses a significant financial obligation to D.M. Archer, Inc. in which the board has concerns about having adequate corporate cash flow to make the payment when due.
Solution: It is assumed by Archer, Inc.’s board that the company will have enough cash flow and cash on hand to cover half the warrant liability when owed in year 10. Archer, Inc. purchased a combination of life insurance policies on selected management with targeted combined cash surrender values totaling $10M in year 10 and enough death benefits to eventually recover the total premium outlays.
Estate Planning
Although shareholders who sell to an ESOP may not be subject to capital gains tax on the stock sale proceeds via IRC 1042, the sale proceeds may still be in the sellers’ estates for estate tax purposes. After employing the estate and charitable planning techniques inherent to typical ESOP transactions and the efficient use of sellers’ lifetime gift and estate exemptions, there still may be estate tax exposure at the death of the sellers.
Risk: D.M. Archer and A.G Archer were very disappointed to learn that their heirs may not receive all that they had intended due to federal and state estate/death taxes. The estimated remaining estate/death tax exposure is $8M based on current tax taw.
Solution: D.M. Archer and A.G Archer purchased a joint survivor life insurance policy in the amount of $8M payable upon the death of both D.M. Archer and A.G Archer to cover the estimated remaining estate/death taxes due at that time.
Conclusion
Obviously, life insurance plays several crucial roles in relation to Employee Stock Ownership Plans (ESOPs). Some or all of these concepts can be utilized based on the specifics of the transaction. Many of the uses of life insurance described can be combined to reduce the total number of policies. Death benefits, premium levels, and cash values should be considered as an aggregate set of policy benefits, rather than as a necessity for separate policies for each individual risk being addressed. It is more advantageous to address the uses of life insurance when the ESOP is initially established, especially when cash flow is more predictable and the associated risks being managed are not currently imminent. Life insurance serves as a significant and flexible protection and accumulation tool that can be utilized to address a wide range of financial concerns, including those inherent in Employee Stock Ownership Plans (ESOPs).
