ESOPs present tax savings opportunity

June 1, 2012
| By Pete Daly |
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West Michigan's strong work ethic and pride in ownership might make it the ideal location for business owners fearing a possible increase next year in the capital gains tax to consider employee stock ownership plans.

Attorney Vernon P. Saper would agree. He jokingly refers to himself as "the ESOP guru." His profile on the Warner Norcross & Judd Web site states he prepared the first ESOP in Michigan  after they were recognized by federal law in 1974. He also is credited with putting together more ESOPs "than any other attorney in the State of Michigan."

Saper said many professionals who work with companies setting up ESOPs see them as "becoming even more popular in the future (because) many of us are expecting … that we will see an increase in the capital gains (tax) rate," particularly if the Democrats win the White House this fall.

In that case, an ESOP "becomes an even more valuable advantage," according to Saper, because it allows a company owner, under certain conditions, to sell his or her stock in the company to the employees without having to pay capital gains tax on that sale. And if that capital gain is ultimately passed on to heirs, no one will ever pay capital gains tax on it.

Brian DeMaagd, vice president of the Michigan chapter of The ESOP Association, also knows a great deal about ESOPs and notes other reasons business owners are considering ESOPs.

"Nationally, I think the numbers (of new ESOPs) have been pretty flat, but locally we're seeing more activity," said DeMaagd. As a manager at Adamy Valuation in Grand Rapids, his job is to work with the owners of private, closely-held businesses to verify the value of those companies in connection with employee stock ownership plans, mergers and acquisitions, succession planning, business litigation and divorce litigation.

DeMaagd said two things are driving the interest in ESOPs.

"What people are paying for companies is starting to move a little bit higher," he said, so business owners who have been waiting out the recession to sell their business may now be "getting more comfortable with what's going on in the market — so more transactions."

A second reason is "a slight uptick in banks that are now willing to finance these transactions," he added.

DeMaagd guesses there are "probably 300" ESOPs in Michigan, with a big concentration of those in West Michigan, that number being close to 100.

Some of the ESOPs in West Michigan include Challenge Manufacturing, which has auto parts plants in Walker and Holland. Buist Electric in Byron Center and Lumberman's Inc. and National Nail in Wyoming are all 100 percent employee-owned ESOP companies, according to DeMaagd.

Three companies near each other in Hudsonville are ESOPs: Speed Wrench Inc., SoundOff Signal and Royal Technologies.

Both Saper and DeMaagd said tax advantages are not the only reason business owners decide to turn their companies over to employees.

One of the newest ESOPs in West Michigan is Perrin Inc. in Alpine Township's Comstock Park, which was started by Randy Perrin in 1995 and supplies silk-screened T-shirts and other sports apparel to resorts, attractions and souvenir outlets across the country. The business has 285 employees at its Alpine Township plant.

CFO Rick Koster said Perrin "wanted to move on and do other things, and just didn't want to sell the company" because so many times, a new owner "comes in and takes it apart and gets rid of people and replaces them."

"The motivation (by Perrin) was really to ensure the continuity of the business, ensure that the people who were with him and helped him start it and grow it, benefit from (the ownership change)."

Wendell Christoff, an owner of salad dressing maker Litehouse Inc. in Lowell, said he and the other two owners of the company, which also has food processing plants in Utah and Idaho, decided to start an ESOP in 2006. Today, the 600-plus Litehouse employees in all three states own 30 percent of the stock, and the company's goal is to eventually have 100 percent of its stock in the ESOP.

Christoff described an ESOP as a "really excellent" way to transfer the ownership of the company "to the people who really helped us make the company what it is today."

DeMaagd said there are business owners in West Michigan who started a business from scratch, spent their lives building it and had an opportunity to sell to a competitor but feared the new owner would fire existing employees, or shut down the plant and move the business to Mexico.

"They don't want that to happen and so they'll take a lower price, sometimes, than what they could sell for to a competitor, in order to protect the jobs," he said.

DeMaagd said those original owners of a business are usually proud of it and want to preserve the company name and reputation.

"They want to keep that legacy. That's a lot of the reason why" they go to an ESOP, he added.

Under the law, an ESOP is structured as a qualified retirement plan. It must meet the same basic rules as other employee benefit plans that fall under the jurisdiction of the U.S. Department of Labor.

"It has to be nondiscriminatory in who it covers," said Saper.

"You can't just set up an ESOP for the executives or the management employees. It generally must be set up for all full-time employees," he said.

Many companies make cash contributions to their employees' 401(k) retirement plans as a routine business expense, but in an ESOP, the company owner is selling stock to the employee ESOP, and the company itself is financing that stock purchase as a deductable business expense.

Obviously, the Department of Labor has an interest in ensuring the price of that stock being sold to the employees in an ESOP is fair. Outside appraisers such as Adamy Valuation are brought in to make sure everything is on the up and up. The Department of Labor continues to keep tabs on ESOPs every year under the Employee Retirement Income Security Act.

One other aspect of an ESOP is naturally attractive to business owners: If the employees' retirement plan is based on the company stock, it stands to reason the employees will really care how well the company is doing.

"There are a lot of studies out there that show that ESOP-owned companies have stronger performances than non-ESOP companies in the same industry," said DeMaagd.

"For a lot of our clients, their retirement ESOP stock has greatly outperformed the S&P 500," he added.

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