For more than two decades, employee stock ownership plans (ESOPs) have served as an effective succession planning tool and a powerful employee benefit while simultaneously providing significant tax advantages and cost-effective financing to the sponsoring company. ESOPs also permit employees to benefit from the success of the business, which can increase commitment to company strategy, productivity and profitability.
Smart Business learned more from Hugh Reynolds, a partner with Crowe Horwath LLP, about how business owners can take advantage of the benefits of ESOPs.
What is an ESOP?
An ESOP is a tax-qualified retirement plan similar to more traditional defined contribution retirement plans and subject to most of the laws and regulations that govern such plans. However, an ESOP has some very unique features. For instance, an ESOP must invest primarily in employer stock and it can borrow money to purchase employer stock. It also has significant additional tax advantages that can make it the ideal vehicle for transitioning ownership for many companies.
In its simplest form, how does an ESOP work?
Essentially, an ESOP borrows money, which it uses to purchase all or a portion of the stock of one or more shareholders. The company then makes contributions to the ESOP, which are used to make the payments on its loan. Unlike with the traditional loan structure where only interest is deductible, the contributions to the ESOP are fully tax deductible. As a result, the company not only gets a deduction for the interest it pays but also on the principal payments.
However, that is not the primary tax benefit available. If the company is an S corporation, the income attributable to the stock owned by the ESOP is not subject to income taxes. Consequently, if the company is 100 percent ESOP-owned, it no longer pays any income taxes. An ESOP is much more tax-efficient as a succession tool than a more typical management buyout structure often used by companies.