Many business owners, especially owners who are thinking of selling their business, wonder if an ESOP is a good ownership transition option for them. The answer is not always easy to determine but an ESOP is something that should be explored. This blog will help in that exploration.
First, what is an ESOP? In general, an ESOP is a special kind of qualified, tax-exempt, retirement plan that owns company stock. Shares in the ESOP are then allocated to company employees. Typically, the ESOP borrows money to purchase stock from an owner either with a seller’s note or by borrowing money from the company or from a bank.
The most common reasons for adopting an ESOP are to: (1) buy shares of a current shareholder; (2) create an ownership culture for employees; and/or (3) set up an organization in which a business does not pay tax.
Future blog posts may discuss the mechanics of selling to an ESOP as well as the availability of other types of employee ownership arrangements (such as an Employee Ownership Trust, which owns the stock of the corporation but is not itself a retirement plan); but this post will focus on the reasons business owners may consider using an ESOP as a way to achieve one or more of those three primary reasons.
Using an ESOP to Buy Shares of a Current Shareholder
A common use of an ESOP is to buy out a current owner. Typically, this is a situation where the owner is considering an exit strategy, but it could also be a situation where the owner wishes to sell a partial stake in the business to his or her employees to motivate them or perhaps simply to sell shares to diversify the owner’s investments. Selling a minority interest in a closely held business is easier to do with an ESOP because it creates a ready market for the owner’s shares, especially when there may not be one to acquire just a minority interest.
In the exit strategy situation, the current owner could sell his or her business to an outsider or a competitor; however, such a sale will not guarantee that the business will continue in its present form. If the current owner wants the business to continue in its present form (e.g., the owner wants the employees to keep their jobs and the business to retain its existing market, reputation, and customer base), an ESOP may be the best option. On the other hand, selling to an outsider could result in many unexpected or unwanted changes and it might even result in the business being liquidated or substantially changed by the new owner.
Selling directly to the employees of the business is generally not feasible since the employees do not themselves usually have the money necessary to meet the owner’s value expectations. In this case, selling to an ESOP can be a feasible option that benefits employees and the owner.
If the company sets up an ESOP, the existing owner’s shares can be sold to the ESOP and paid for, over time, with the earnings of the company. There can be tax benefits to the selling owner (e.g., if the company is a C corporation, the selling shareholder might be able to defer the tax on the sale if certain conditions are met, or in some cases, maybe not owe any tax at all). There are also tax benefits to the company in using an ESOP, since the company itself gets to deduct the payments for the purchase of the shares by the ESOP (note that if the ESOP owns 100 percent of the sponsor, which is organized as an S corporation, deductions are unnecessary, as discussed below). Contrast this to a stock redemption of the selling owner, on the other hand, which is not deductible by the company.
Using an ESOP to Create an Ownership Culture
An ESOP is a vehicle to create an employee ownership culture. Once employees realize that the performance of the company directly affects the value of their retirement accounts, the employees generally care more about positively affecting the company’s results. How does this happen? ESOP shares acquired from the selling owner are allocated to the employees’ ESOP retirement accounts. Even though an employee is not a direct owner of the stock, an employee’s retirement value is directly impacted by the value of the business, which, in turn, reflects the profits and losses of the company that is being acquired by the ESOP. (ESOP stock must be valued each year and the stock value directly impacts the value of the retirement accounts of the employees.)
This direct relationship between the employees and the company shares acquired by the ESOP gives employees an indirect financial (equity) interest in the business. The added benefit to the employees is that their “ownership interests” accrue value as part of their retirement benefits. The employees get the benefits of employee ownership without having to buy the stock themselves.
Using an ESOP to Save Current Tax on Profits
Many companies set up ESOPs to avoid paying taxes on profits. This result obtains, for example, if an ESOP owns 100 percent of the stock of an S corporation. In this structure, neither the company nor the company’s sole shareholder (the ESOP) pay any taxes on the S Corporation’s profits currently. Instead, taxes are paid by employees only when they cash in their retirement benefits from the ESOP or, if their retirement account is later rolled over into an Individual Retirement Account, when they cash out of that account. At that time, the retiree pays ordinary income tax on the value of the benefits paid from that IRA account.
In other words, a profitable S Corporation business does not pay corporate tax itself and the S Corporation’s shareholder here, the ESOP, does not pay tax on the S Corporation’s earnings since the ESOP itself is a tax-exempt retirement plan. Taxes will be paid eventually when an employee starts drawing his or her retirement benefits. Businesses in the S Corporation form like the idea that there are no current taxes. The cash tax savings from such an arrangement can be used for such items as growing the business, paying better compensation to attract top employees, helping competition by keeping product prices low, etc.
ESOPs are not for every company or every fact pattern involving a selling owner. In general, only companies that are organized as a “corporation” for tax purposes can adopt an ESOP. It may be possible for an LLC to adopt an ESOP, as the IRS has previously approved the sponsorship by an LLC (provided the LLC elected to be taxed as a corporation). Other factors, such as profitability, size of the workforce, expenses, etc., are important factors to weigh in deciding whether an ESOP is right for a company. An ESOP feasibility study can make the analysis and decision easier. But, when properly analyzed and implemented, ESOPs can clearly be a “win – win” for everyone and can provide solace to selling owners that their business will continue on with parties having the same commitment, respect, and reverence for the business that the owner had.
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