When business owners think about succession planning, they often picture selling to a competitor, a private equity firm or their management team. But there’s also a lesser-known option that can ensure business continuity while reaping tax benefits and motivating loyal employees — an Employee Stock Ownership Plan, or ESOP.
Forming an ESOP can boost profits, motivate employees and provide tax benefits all around.
It’s not something you do overnight, and you have to be committed to it for the long term, but it’s an absolutely wonderful way of rewarding your employees.
What is an ESOP?
An ESOP is a qualified retirement plan, governed under the retirement laws of ERISA. About 11,000 U.S. companies currently have ESOPs that cover more than 13 million employees, according to the National Center for Employee Ownership.
An ESOP creates a trust fund that holds shares in the company on behalf of employees. The company can sell shares to the plan, or it can donate or lend cash to the plan to purchase shares from existing owners. Company contributions to the plan are tax-deductible, within certain limits.
Shares in the trust are allocated to individual employee accounts, which vest over time.
What are the benefits of ESOPs?
Most studies show that ESOP companies have a higher level of productivity and profit than comparable non-ESOP companies, because everyone is an owner. Even if an employee owns one-tenth of one-tenth of a percent, it can help with retention and morale over the long haul.
Employees gain extra motivation when they know that increased profits means an increase in their own personal wealth. Their ESOP shares become an added source of retirement savings.
An ESOP can also be a differentiator between companies. Potential hires choosing among two comparable employers may be swayed by the one that offers an ownership stake.
What are the tax benefits?
The tax benefits are incredible. An ESOP lets you buy the equity of the company from the owner using pre-tax dollars. Essentially, an ESOP sale is an ‘earn out’ — and while an owner is earning himself out of the business, there is the potential to reduce the burden of federal taxes.
In the case of a 100 percent sale of an S corp, the company is no longer subject to federal income taxes. In addition, if an owner sells a portion of his shares to the ESOP, and immediately after the sale, the ESOP owns at least 30 percent of the outstanding shares, the gain can be deferred and the proceeds of that sale can, in most cases, be invested on a tax-deferred basis, so the owner isn’t paying any taxes until he or she sells that second investment.
For example, if you own a company worth $10 million and you sell $3 million worth of shares, you can invest that $3 million in the market and not pay any current tax on the gain, even if the cost of the original shares you sold was nothing. It’s not until you sell the shares in the new investment that you have to pay taxes.
Another benefit for an S corp is that if it does a leveraged ESOP, it doesn’t pay taxes on the portion of the shares that are held by the ESOP. There are some ESOPs that are 100 percent ESOPs, and because the company is an S corp, it doesn’t pay corporate income taxes.
Which kinds of companies are the best matches?
ESOPs work well for companies that are stable and growing, and that have a strong belief in their employee base.
Where an ESOP doesn’t work well is at a company in which revenue and profits are volatile, because prices and valuation can go up and down quickly. It has to be a company that is in it for the long term and that is stable and growing.
In addition, there are costs associated with implementation and maintenance, so there aren’t many at companies with revenue of less than $5 million to $10 million.
How would a company begin to form an ESOP?
There are firms that specialize in forming and running ESOPs, and the process requires the help of several professionals. You need a valuation company that does an annual valuation of your business to establish the fair market price. You also need multiple lawyers to represent the company, the ESOP, and perhaps the selling shareholders.
Because an ESOP is an ERISA plan, there are labor and income tax regulations to deal with as well.