ESOP: Fables, facts and foibles

When the parent company of the Milwaukee Journal went public in 2003, the event produced once-in-a-lifetime windfalls for 2,250 staffers who had invested in its employee stock ownership plan.

But all ESOPS are not alike. The plan being created for Tribune Co. is significantly different from the Milwaukee plan, except in one respect: All ESOPs share the common trait of delivering major tax benefits to a company that has one. More on that in a moment. First, here’s some background:

For secretaries, printers, editors or any other employee who invested regularly in the Journal Communications ESOP in the 10 years prior to the IPO of the Milwaukee company, the offering delivered a gain of nearly tenfold, according to the New York Times. “Where [else] could we have ever done this?” said a bookkeeper after learning she was an instant millionaire.

Thanks to a benevolent owner who placed 90% of his company in the hands of its workers, Journal Communications was a successful ESOP. Perhaps the saddest part of the story is that barely more than a third of the company’s 6,000 employees took advantage of this extraordinary opportunity.

But not every ESOP leads to a happy landing, as the more than 70,000 employees of United Airlines learned after purchasing 55% of their company with their retirement funds in 1994. When United declared bankruptcy in December, 2002, the employees of the largest ESOP in history lost approximately two-thirds of the $3.3 billion invested in the plan, according to documents filed in an unsuccessful class-action suit seeking to recover the loss.

Although the idea of workers owning a piece of the company employing them sounds positively Marxist, an ESOP really is a clever capitalist tool enabling a business owner to cash out of a significant portion of his company while saving on taxes and retaining control of the enterprise.

In typical circumstances, employees investing in the ESOP don’t get to see the company's financial information and have no vote in its management. Enabled by federal legislation in the 1970s, ESOPs deliver tons of favorable tax treatment to a company.

When the owner of a business puts seed money into an ESOP intended to fund the eventual buyout of a portion of his company, he gets a tax deduction equal to the amount of money funding the plan, as well as deductions for the principal and interest on any loan he takes out to create it.

In the case of Tribune, immediate tax benefits will be generated from the $250 million put into creating an ESOP in the first stage of the complicated, multi-step transaction that will take it private, according to a company press release.

The tax breaks get better when the owner actually sells some of his holdings to the ESOP. If an ESOP buys 30% or more of a C corporation from the owner, then all the gains of the sale are tax free to the owner, so long as the proceeds are held in qualified investments.

The structure planned for Tribune appears to build in an immediate gain for the ESOP, along with an accompanying tax benefit for the current investors who sell their shares in the business. The ESOP is scheduled to be funded at $28 a share and then rolled into a structure priced at $34 a share, generating an 21.4% gain in perhaps less than 12 months.

The Tribune Co. will be structured as subchapter S corporation, insulating it from the requirement of paying coporate taxes and, thus, enabling it to keep more cash in the business. S corporations pass all profits (or losses) to individual shareholders, who are responsible for paying any resulting taxes.

While profits always are good, tax losses also can valuable to investors like San Zell, who may want to reduce the taxes owed on gains from other projects with certain near-term losses generated by Tribune Co. The Trib's ESOP would not be responsible for paying any taxes, though individual employee shareholders would have to pay taxes on any gain they realize when they eventually sell their shares.

While participation in the Journal Communications plan was voluntary and the company even arranged low-interest loans for employees who wanted to buy more shares than they otherwise could afford, the Tribune plan will be solely funded by the company as part of multi-tier retirement program. Unlike the United plan, Tribune employees eligible for 401(k) retirement accounts will be able to continue to invest in those accounts and, thus, diversify their pension portfolios.

As demonstrated in Milwaukee, ESOPs can be a beautiful thing for employees when a company is successful. But they can be a nightmare if things go wrong.

If most or all of employee retirement funds are invested in a company’s ESOP, as was the case at United, then the collapse of the business could wipe out everyone’s pension. If the company itself goes out of business, as happened to one former General Motors unit purchased by its workers, then people would lose not only their pensions but also their jobs.

Much more needs to be learned about the specifics of the Tribune plan, which is not likely to be a plain-vanilla implementation. But the structure suggests the following implications:

:: Restructuring as an ESOP will enable Tribune to efficiently raise cash to buy the shares of such dissident shareholders as the Chandler family, while enabling the departing shareholders to shield much, if not all, of any gains from taxes.

:: The tax advantages associated with an ESOP will enable Tribune to save on the costs of borrowing money, thus providing more working cash, lowering borrowing costs and potentially enhancing profitability. This will give Tribune a less-dear alternative to outside financing.

:: With additional cash available to fund the business, Tribune either could pay investors higher dividends or use the funds to make strategic investments for the future in niche print products, new-media projects and the like.

:: Operating as a private company no longer required to satisfy unrealistic Wall Street expectations from quarter to quarter, Tribune can take a longer-term view of its business. Although the tax and financing benefits of an ESOP might put a bit less pressure on the company to cut expenses than public or private ownership funded by private-equity investors the continuing uncertain revenue environment for newspapers may persuade management that it is prudent to reduce such expenses as headcount, newsprint consumption, television programming and more.

Advocates say ESOPs improve sales and cut expenses by raising productivity and morale. It remains to be seen whether an ESOP will turn Tribune into the Promised Land.

But the company's anxious employees probably are more than happy this Pascal season to be coming to the end of what must have felt like 40 years of wandering in the desert.