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For most closely held business owners their business is their biggest asset. At some point, all business owners will consider transferring that ownership in order to diversify their investment or simply to enjoy the fruits of their labor. When planned and implemented properly, an Employee Stock Ownership Plan (ESOP) can help business owners achieve these goals without losing control of the business. An ESOP is an employee retirement plan that allows employees to invest in their employer’s company. An Employee Stock Ownership Trust (ESOT) is formed to oversee the administration of the ESOP. In addition to providing liquidity, an ESOP can and also be a powerful tool for succession and financial planning. Since it was specifically designed for this purpose, there are several tax advantages that are not available to other types of retirement plans.
An ESOP allows a business owner to sell a portion of his business and still remain in control. Typically, if the business interest is sold to an outside party, the owner may need to negotiate the percentage of ownership sold, the terms of employment, salaries, and fringe benefits. In an ESOP, business owners can sell all or a portion of their interest. The timing is also flexible; the business owner can sell whenever they are ready to sell.
If the business is a C Corporation, when the ESOP owns 30% or more of the company ownership, gains on the sale of interest to the ESOP can be deferred if the owner reinvests the sale proceeds in qualified securities within 12 months from the sale. The owner can defer the gains indefinitely as long as the funds are invested in qualified securities. When the owner dies, the securities are included in his estate and his heirs get to step up in the bases of the securities and the deferred gains disappear.
Note: at the time this article was written, there existed an estate tax and a basis step up requirement. As of January 1, 2010, the estate tax has been repealed. However, most commentators believe that the
The deductible dividends are limited to the shares that were purchased with the loan proceeds. the company earnings will be entirely tax exempt. The employer is able to contribute more funds to the ESOP for repayment of the loan. Impact on Balance Sheet . Deductible Dividends In the case of a regular C corporation. perhaps retroactively. the non-ESOP shareholders can decline the dividend before it is declared. and dividends distributed to non-ESOP shares are not deductible. Dividends are also deductible if it is a cash dividend and if it is actually distributed to the ESOP participants. Disadvantages Before implementing an ESOP. a portion or the entire company earnings is exempt from taxation depending on the percentage of ownership by the ESOP. If distributions to non-ESOP shareholders are not desirable. Keep in mind that dividends should be distributed to all shareholders in the same class. dividends made to a leveraged ESOP are deductible if the dividends are used to repay the ESOP loan. This is useful when the maximum contribution (25% of eligible payroll) is not sufficient to repay the annual payment. An ESOP creates a “tax shield” and earnings that are allocable to the ESOP are not taxable. business owners should evaluate possible problems and disadvantages. Cash dividends are deductible only with respect to shares that have been allocated to ESOP participants. if the company is owned entirely by an ESOP.tax will be reinstated. Thus. Tax Exempt Earnings In the case of an S Corporation.
Company Performance If the company value does not increase. the company stock is less attractive and employees may wish to invest their retirement funds somewhere else. or there is appreciation in the stock’s value. If the company borrows money and lends it to the ESOP to purchase the company stock. In addition. the loan is reported as a liability on the company’s balance sheet and a contra equity account reducing its equity is created. there is an increase in number of retiring employees. Liquidity The company will need to monitor its cash reserve for the repurchase obligation to its departing employees.The company’s equity is reduced in the case of a leveraged ESOP. Like most everything. . employees will lose their retirement funds that are invested in the company. Although this may not impact the company’s operation. especially if a majority of the shares are vested. if the shares sold to the ESOP are overvalued. Losses may be severe if the ESOP investment is not diversified. if the company fails. an ESOP has its own pros and cons. the seller will be subject to 15% penalty tax. the reduced net worth may affect the company’s ability to obtain contracts or bonding when net worth is one of the key considerations. Valuation An annual valuation is required to establish the stock value for purposes of making contributions and purchasing stock. Business owners should consider every aspect of the plan and all possible impacts before adopting an ESOP. In the worst case scenario. It takes a substantial amount of planning and evaluation.