Friday, March 6, 2015

S Corporation ESOPs

Twelve years ago I was working at my second nine to five job post college graduation. My first job I had lost due to most of my work being shipped overseas and then closely followed by the tech bubble crash of 2001. Two weeks after getting laid off, 9/11 happened and jobs dried up except for those companies truly desperate to hire someone. I found one of those truly desperate companies and put in two years. The problem was that my boss was an alcoholic and was disappearing for weeks at a time on benders leaving me to shoulder his burdens as well as my own. His boss, desperate to keep me happy and perhaps to eventually unsurp my boss, asked what I wanted to do long term for this company and I told him. I received training from the company and pitched them my idea of how I could use my skills to increase their business. They must have agreed because they hired someone else to fill that position, leaving me to do a job I was extremely over qualified to do. My boss still kept coming back from his mysterious benders and his boss continued to just look the other way. Disgusted, I started looking elsewhere.

I was making decent money at the time and found lots of companies in 2003 that were looking to hire people but most were only paying a fraction of what I was earning. More importantly, all of them seemed like I would just be another number and I desperately wanted to work for a company where I was a name and not just a number on a resource sheet. Finally a company of which I had never heard just 40 miles up the road from where I grew up found my resume online and gave me a call. I went down a few days later for an interview.

The company seemed exactly like what I was looking for. It had a small group of people creating a product that a much larger number of people down on the factory floor built. I could be as hands on as I wanted and everyone knew each other's name. They must have really liked me because before I completed the two hour drive back to my home, they had left a message offering me the job and a second message increasing the offer in the first message by another $5k. It was still about $10k less than what I had been making but it seemed like the right move at the time. I accepted and gave my current boss fresh back from one of his benders my two weeks notice. Perhaps not coincidentally, my boss was fired two weeks later.

While signing paperwork and going over benefits at my new employer, the Human Resources manager happened to mention that they were an S Corporation and were an ESOP. I had never heard of either of those terms and figured as long as I got a paycheck it really didn't matter what kind of company they were. It was only later that the gravity of that statement hit me and in a very surprising way.

S Corporations were signed into law in 1996 and they are a closely held company that does not pay any federal taxes. Instead, they pass on their income or losses to its shareholders who then must report it on their federal income taxes. This brings me to ESOP which stands for Employee Stock Ownership Plan. S Corporation ESOPs have to have less than 100 share holders to meet the definition of closely held. Unbeknownst to me, I was joining a group of about 50 such people and was going to be one of 50 employees who owned 100% of this company.

I started in the fall and because I had to work a full calendar year before I officially became eligible to receive profits (or losses) into my company ESOP account, it took awhile for me to grasp the benefits to being in such a position. But nearly 18 months after I started when I received my first statement, everything became crystal clear. I was paid a salary and like normal, it came every couple weeks with federal and all the other taxes withheld from it. However, once a year, the company divided up its profit to these 50 shareholders according to a complex formula and put these into an account for us in the form of company stock. If my share of the pie was $1000, they put $1000 worth of company stock into my account. Except it wasn't just a $1000. The first year I received an ESOP allotment, it amounted to about 75% of my salary.

But there is a rub. Since this money isn't federally taxed, I must pay the taxes but because it is in shares and treated similar to a 401k, I don't pay taxes on it until I withdraw the stock/money from the tax advantaged retirement account it is parked in. In short, it is treated like a 401k in that I can't touch the money until I retire or pay enormous tax penalties.

Another advantage/disadvantage depending on which side of the coin you are on is that because it is tied up in company stock, the way your stock price goes, so too goes your ESOP account. Because we were 100% employee owned and thus were a private company, our stocks weren't traded publicly. Instead, once a year we hired a company to come in and evaluate our entire company assets minus our liabilities to see how much we were worth. That was divided by the number of outstanding shares of stock and directly determined our stock price per share.

Someone at our company however figured out a way to work the system. If we bought another company with cash and its assets minus liabilities was greater than what we paid for them, then our combined companies would be worth a lot more and thus our share values would increase. Over the next decade, we would buy a half dozen of such companies. Due to this and the fact that we were profitable as individual companies, over the decade that I worked for this company, our average annual stock share increase was 26%. For comparison, the S&P500 during the same time averaged only 7.34%. Put another way, at 7.34% growth, your money doubles every 10 years. At 26% it only takes 3 years.

I watched my ESOP statement grow exponentially as the years went by. As our companies did better and made more money, the amount being put in our ESOP accounts dwarfed our salaries. I should have been ecstatic but I wasn't. While our retirement accounts were getting fat, our salaries were stagnate and it felt to me that we were being enticed with a proverbial carrot on a stick. Eating a portion of that carrot right now would be nice but instead we were chasing it until our retirement and making what we had stretch further every year. It seemed like our company was being driven out of greed to do everything to fund our ESOP accounts and make us wealthy down the road while starving those of us who were rank and file members in the present tense. I also worried that because some tax code law changed in 1996 to make these companies exist, it could also go back the other way. What especially worried me was lots of talk of massive tax overhaul if ever there is a congress willing to work with each other. (Far fetched but could happen.) It got to the point where our company was joining other such companies to create a lobby group to make sure their S Corporation ESOP status wasn't revoked. If that happened, all that was in our accounts could disappear as stock prices plummeted from having to pay federal taxes before determining profitability. To complicate this even further, due to such a large number of account balances in our ESOP plans, the company made the decision to stop paying out this money in one lump sum but distribute it over five years. Essentially that meant that if the company went tail up, we had to see it six years in advance in order to fully get paid out. (You have to have a full year of ESOP ineligibility before you get your first check.)

At the end of ten years, my account had grown to the point where I could retire very comfortably when I reached the age of penalty free withdrawals of 59-1/2.  Trouble was, I wasn't 59-1/2 years old and wouldn't be for another 20 years. I began toying with the idea of getting out while the getting was good. Also causing me to toy with this idea was that because we bought all these companies, I was becoming a number again and though I was still a member of the original 50, there were signs that getting rid of these original owners, especially the lower rank and file ones like myself, would be greatly beneficial to those higher ups that remained. I wanted to quit but when you are sitting behind the goose that lays the golden eggs and the goose keeps popping them out, it is hard to not just say one more egg. Eventually as I predicted but didn't heed, I was laid off along with quite a few of the original 50.

I will soon receive the 3rd of my 5 installments of my ESOP account and like the previous two, I just roll them over into a self directed IRA account towards my retirement. Since I left, I no longer get new shares issued into my account but the uncashed out stock still receives any stock increases and the last three have averaged 29% which means my account more than doubled without working a day. I am getting confident that the company will be around for at least two more years at which point I will fully be cashed out from them.

Looking back, all this seems too good to be true and indeed if you search for S Corporation ESOPs online, there are numerous sites that say they are essentially a tax evasion scam. Although while working there, it all seemed on the up and up, now not having the pressures of money sitting in an account with a promise I'll see it when I leave the company if the company still exists, it does have a scam like feel to it. I get lots of questions about ESOPs from various people I know asking how it worked and I struggle at times on the best way to answer. This post is essentially my answer. I did very well and was able to essentially retire 25 years before most people do as long as my wife keeps working and paying for our health insurance and current expenses for the time being and bless her heart, she does want to do that. But I have no doubt that eventually this house of cards will come crashing down. Instead of the federal government getting lots of money in taxes now, former employees of S Corporation ESOPs will eventually be paying it back to them in small amounts because our incomes upon retirement are significantly lower. The only question in my mind is who will be left in these corporations holding the bag when the end comes.


sage said...

Take the money and run!

Ed said...

Sage - I most certainly am which is why I've been holding my breath for nearly three years. Still, I occasionally have a twinge of regret of what could have been had I stayed on a few more years but then I realize that would just be plain greed talking and know that I made the right choice. As they say in poker, I cashed out my chips while I was ahead.

kymber said...

Ed - if i had have stayed in the fed gov for 5 more years, my monthly pension payments would have increased by about 28%. and if jam had have worked that extra 5 years, we really could have socked back the money. but there were various circumstances, such as a new mcmansion going up on both sides of us where we had grown too used to our privacy. and i was able to retire - so we thought about it and decided to do it. we are like you in that we are still young enough to really get the most out of the next 20yrs before true retirement age kicks in. and honestly, that extra money that we could have made is nothing in comparison to how happy we are and how much more we have learned about designing a lifestyle for us.

i think you made the absolute right choice. congrats! your friend,

Anonymous said...

Reading this what gave me pause was the moved to fold in other companies for that's where it seems moody. On the face of it a small maker of farm gates(say) with that 100 emp-shareholders trading over a few counties putting cash aside for a pension in lieu of federal taxes is a good for the worker-owners and the government. It keeps a degree of ready capital from trade while keeping people off unemployment.
OK, here in Ireland in the 1890 the Co-Op movement began, now there are perhaps 10 major ones left with four of then on the lisy of the top ten food corporations in the world and, here's the kicker they are still for taxation proposes trading as Farm Co-Ops.
I think they are a scam.

Ed said...

Kymber - Interesting story. I always wondered how you were able to support your BOL and now I know. Most of my peers don't save anything much less for vacation. But the older generation that I have been around, I have seen way too many who finally retire and then die before they get to enjoy it. I never wanted that to happen to me. It also helps that my idea of retirement isn't fancy cars, yachts, and flying first class. My idea of retirement is a lot closer to you and Jambaloney!

Vince - To qualify for S Corporation ESOP status, the number of employees has to be small, which thus dictates that it is privately held. That in turn drives that the only way share value goes up is if the company grows. If the company did not grow, the amount of money given through share dividends would be quite small comparatively and probably nobody would be interested in it. It is kind of a vicious cycle and probably not one that is sustainable.

kymber said...

Ed - some more backstory just for your own understanding. i served 10 and a bit years in the military and when i joined the public service/fed government..i had an awesome HR rep who asked me if i wanted to roll my pension over. she explained that my military pension was worth 15yrs (which got me 4weeks vacation a year and 25 sick days that i could roll each year). i said of course. then i ended up working taking only a week or 2 off a year for another 11 years at the fed gov jobs. so my sick days and vacation days just kept rolling over and i think at the end i had accumulated over 2yrs additional time from sick leave, vacation leave and overtime (you are not allowed to roll over time anymore). in addition, the military pension plan that i joined under and paid to, changed the year after i left the military. i was under a very specialized plan that when it was changed over to civilian, was not the same plan that other public servants were under. so i hit 25yrs working time very early but because i was nowhere near 55 i was penalized when i retired but still had enough of a monthly pension that jam and i could safely retire by cutting back, growing and preserving our own food, etc. i think that you and i can count our lucky stars on serendipity. being hard workers and being in exactly the right place at exactly the right time! i have many ex-military friends who got out a few years after me - cashed out their pensions for a few measly thousand, and now will have to work until 65. i have always thanked my lucky stars for good choices and timing! i think you are the same!

i hope this helps to explain the really unique position that we found ourselves in when i was legally able to retire. again, i think you made the exact right decision! much love to you and yours!