Sinking Fund vs. Insurance Funding
Which repurchase liability strategy actually works for ESOP companies?
ESOP companies that recognize the repurchase obligation typically consider two primary funding approaches: a sinking fund (dedicated cash reserve) or corporate-owned life insurance (COLI). Both have merits. But they are not interchangeable, and understanding the differences is critical to choosing the right strategy—or, more commonly, the right combination.
The Sinking Fund Approach
A sinking fund is straightforward: the company sets aside cash in a dedicated reserve each year, invests it conservatively, and draws from the reserve when repurchase demands arise. The advantages are simplicity and control—the money is there, it’s visible on the balance sheet, and it can be accessed at any time.
The disadvantages are significant. Sinking fund contributions are made with after-tax dollars. The investment earnings are taxable annually (for C corporations; S corp ESOPs that are 100% ESOP-owned may not face this issue). The effective growth rate, after taxes and conservative investment returns, may be 2–4% annually—while the share price (and therefore the obligation) may be growing at 6–8%. This means the fund falls further behind the obligation every year unless the contributions are increased aggressively.
Additionally, sinking funds are vulnerable to business downturns. When revenue drops and cash is tight, the first casualty is often the voluntary contribution to the repurchase reserve—precisely when the obligation itself has not decreased.
The Insurance-Based Approach
Corporate-owned life insurance (COLI) addresses several of the sinking fund’s structural weaknesses. Permanent life insurance policies build cash value on a tax-deferred basis, growing more efficiently than a taxable reserve. The cash value can be accessed through policy loans (typically tax-free when structured properly) to fund scheduled repurchases. And the death benefit provides a large, immediate, income-tax-free lump sum if an insured participant dies—precisely matching the event that triggers the obligation.
The insurance approach is particularly effective for the concentrated risk in an ESOP: the handful of participants with the largest account balances whose departures will create the biggest cash demands. Insuring these specific lives creates a funding asset that is directly tied to the liability it is meant to cover.
The Right Answer Is Usually Both
In practice, the most robust repurchase funding strategies combine insurance with a supplemental sinking fund. The insurance covers the concentrated risk of high-balance participants and provides the tax-efficient accumulation vehicle for the bulk of the obligation. The sinking fund provides a liquid buffer for unexpected departures, smaller-balance distributions, and any shortfall between the insurance cash value and the total obligation.
The allocation between the two depends on the company’s specific demographics, cash flow capacity, tax structure, and the concentration of account balances. A 100% ESOP-owned S corporation with a heavy concentration in five participants will have a very different optimal mix than a C corporation with broadly distributed balances.
SSG Financial Group designs customized funding strategies that combine insurance and reserve approaches based on the company’s specific repurchase projections. Schedule a 20-minute consultation to model your optimal strategy.
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About SSG Financial Group
SSG Financial Group provides integrated insurance and financial planning solutions for ESOP companies, business owners, and their advisory teams. Our focus areas include ESOP repurchase liability funding, wealth transfer, business transition planning, and executive benefits.
