Realizing the value of your business without losing control
Are you efficiently managing risk? If your company has an active employee stock ownership plan (ESOP), you understand the value such plans create for the participants and the original owner. With this value comes two major risks: repurchase obligation and partial ownership transfer.
Repurchase obligation
Like most ESOPs, your plan probably requires that ownership interests only be held by active employees of the company. Therefore, if an employee in the plan leaves the company or dies, the terms and conditions of the plan will trigger a repurchase of the employee’s shares. To manage this risk properly, it is important to periodically review the repurchase obligation study, the resulting liability, and—the corresponding assets held in reserve. The need to maintain these funds in liquid, conservative investments limits your return.
With the use of institutional life insurance products, that cash reserve could be used to fund a corporate owned life insurance (COLI) policy on key participants, while producing competitive returns and remaining fully liquid. Groups of ten-plus covered persons may not require medical underwriting. Notice and consent requirements of IRC Section 101(j) will apply. These policies are considered a cash equivalent, do not have surrender charges and earn interest less any mortality charges.
- Should a covered participant die, the proceeds would be paid to the company to fund the repurchase obligation. Any benefit amount above the repurchase obligation would be retained by the plan.
- Should an employee leave the company, funds could be withdrawn from the cash value of the COLI policy to meet the repurchase obligation.
Partial ownership transfer
Not every ESOP involves an immediate sale of all the owner’s shares; instead it can be completed through several transactions. In this case, there is usually a buy-sell agreement in place so that the remaining shares are purchased by the company, rather than being transferred to the owner’s heirs. Depending on how much of the ownership transfer has been completed, this purchase could be a considerable amount—causing a significant strain on cash flow or added debt during the time of an accelerated transition.
A buy-sell agreement would have been established with the company, but there may not have been a funding mechanism outside of cash flow. By implementing a life insurance policy to fund this transaction, if needed, the participants in the ESOP can take comfort in knowing that should the owner die before the transfer completes, they can assume control without an additional financial burden on the company.
An ESOP can be a useful tool for business succession and employee engagement; however, it also creates a repurchase obligation — the company's future responsibility to buy back shares from departing employees. As ownership transitions, especially partial transfers, this obligation can create significant financial strain if not properly planned for. Life insurance is often used as a funding strategy to help meet repurchase needs efficiently and predictably. With tax-advantaged benefits and liquidity at the right time, it can support a smoother ownership transition, protect your company's cash flow, and ensure long-term financial stability.
