How to Use an ESOP to Settle a Divorce

If you have a business worth at least $5 million and there isn't enough cash to fully satisfy equitable distribution (an "ED Shortfall"), consider forming an Employee Stock Ownership Plan ("ESOP") to facilitate a settlement of your divorce.

How does an ESOP help a case settle?

By Noah Rosenfarb

The simple answer is that Uncle Sam chips in by allowing the payment for the value of the business to be "tax deductible." ESOPs are complex and tend to scare owners away because there is a perception that "employees get stock in the company" (which need not be true). Put aside any hesitancy you may have and consider the following example: Husband and Wife have a $12 million marital estate that includes:

  • ABC Company (operated by Husband) worth $10 million;
  • Marital home worth $1 million; and
  • Cash and retirement assets of $1 million.

During settlement discussions, Wife will agree to let Husband keep ABC Company if Wife gets the house, cash and retirement assets and an additional $4 million. Husband could agree if he had the $4 million. Husband's options if he doesn't want to sell to a third party include:

A. Borrow $4 million from a bank;

B. Pay Wife over time; or

C. Create an ESOP.

If Husband chooses A or B, he would need to earn approximately $7 million to pay Wife $4 million because he would pay approximately $3 million to Uncle Sam (assuming a 42% tax rate). At all times, Husband owns 100% of ABC Company.

Let's consider that ABC Company creates an ESOP. The ESOP borrows $4 million from a bank to buy 40% of ABC Company from Husband. Husband now has $4 million in cash and owns 60% of ABC Company. Husband then transfers the $4 million to Wife. If Wife invests the sale proceeds in stocks or bonds of US companies (like General Electric, Microsoft, and hundreds of others), neither Husband nor Wife has to pay capital gains taxes (yet).

In order to repay the bank loan, the Company contributes $4 million to the ESOP over a period of years. Because contributions to an ESOP are tax deductible, the business would need to earn only $4 million to repay the loan.

In examples A and B, Husband earns $7 million to payout Wife and owns 100% of ABC Company the whole time. In example C, Husband earns $4 million to payout Wife and owns 60% of ABC Company. So, in some sense we're comparing apples and oranges because ownership is different. However, the remaining 40% is not owned by individual employees but, rather, by the ESOP, which is controlled by a trustee. The employees are merely the financial beneficiaries of the plan.

Also, there are so many intricacies when it comes to ESOP design and structure that in the end, a good expert team can bridge a substantial portion of this ownership gap. In addition, companies with an ESOP generally grow faster than "traditional" companies. A Rutgers University study states that, on average, implementing an ESOP will result in an additional 33% growth over 10 years. According to the National Center for Employee Ownership, ESOP companies with "participative management" grew 8% to 11% faster than they would have otherwise. Faster growth leads to larger increases in value - so the Husband's 60% of ABC Company is likely to have more value after 5 years under this example than 100% of ABC Company would with traditional financing.

That said; using an ESOP is not for everyone. One should only pursue an ESOP if they should expect their company to grow and increase profits, and believe that employees are an integral and important part of their success.

Copyright 2009

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