Most business owners don’t start a company thinking about the day they’ll retire and leave the company in someone else’s hands. The business they founded is a large part of their identity and their life. But when they’re ready to retire or reduce their role in the company and welcome new ownership and leadership, it’s a relief to know they’ve left their enterprise in good hands. An excellent way to do that is with an ESOP, an employee stock ownership plan.
An ESOP isn’t just an ideal vehicle to transition ownership and boost the founder’s liquidity; it’s also a superb opportunity for business owners to save on federal income taxes while encouraging employee productivity.
Creating and administering an ESOP is a smart move for many forward-thinking business owners, says Bill Norwalk, a tax partner at Sensiba San Filippo, a CPA and business consulting firm with four offices in the San Francisco Bay Area. He has nearly 30 years of expertise advising company owners on ESOPs and tax-related matters.
Smart Business recently asked Norwalk about vital details of ESOPs that savvy business owners should know.
What is an ESOP and which businesses should consider one?
Simply put, it is an employee retirement plan. It’s a tax-exempt trust that gives workers shares in the company that employs them.
Key factors for a company considering an ESOP are profitability and size. A business needs at least 25 employees and should have an independently appraised value of at least $4 million to make it worth the cost and effort to set up an employee stock ownership plan. There needs to be a significant payroll — I advise at least $1 million — because payroll generates the contribution to the retirement plan that provides funding for the stock sale.
ESOPs are especially beneficial for owners interested in liquidity with a solid history of earnings and the ability to attain financing. The company also needs a capable management team with a clear vision and succession plan for when the owner/stockholder is ready to sell his or her shares and leave the business. The owner’s day-to-day activities as an employee also need to be transitioned prior to his or her departure.
How popular are ESOPs?
There are about 11,400 ESOPs and other profit-sharing plans invested mostly in employer stock with about 13.7 million participants, according to the National Center for Employee Ownership. The value of those assets is an impressive $923 billion. Small businesses are most likely to create ESOPs; 72 percent of the ESOP Association members, a national non-profit membership organization, have less than 250 employees.
But I’ve helped companies of all sizes create ESOPs. One of my clients is a profitable business, which has a stock value of approximately $6 million. After years of hard work, he wanted to retire but remain involved in the business on a limited basis. He agreed to sell 30 percent of his shares to the business. He was able to defer the gain on the significant amount of cash he received because he reinvested the funds into qualified replacement securities, which is stock or long-term debt in U.S. companies. So he gets a steady return from a diversified portfolio, and he has reduced his day-to-day involvement in the business’s daily activities.
His company benefited too. It saved significant income taxes because of the money it contributed to the plan. The value of the shares owned by the plan increased, benefiting the employees, who will, over time, vest in those shares.
How does an ESOP aid a business owner?
An ESOP can help owners in several ways. It provides liquidity while they continue to work in the business overseeing the company’s transition to new ownership. The ESOP provides reliable cash flow for a retired owner, who’s been able to sell the business without paying federal income taxes on the sale. The owner benefits from being able to replace company stock with securities that yield cash, deduct interest and principal on loan repayment and ultimately create a company that pays no federal income taxes. That’s a significant advantage in any marketplace.
A business owner often leaves profits in the business to help it grow. The value tied up in the business is often the owner’s largest asset. Founders feel a sense of personal responsibility to the employees who helped build the business, and they want to see the business flourish long after they leave. At some point, they are ready to reduce their involvement in the business, retire, or preserve value outside of the business for their heirs. In the right circumstances, an ESOP can help achieve each of these goals.
What are some advantages of an ESOP for employees?
It’s free money. In fact, retiring employees can end up with more value allocated to them by the company through an ESOP than through a 401(k). A company can even offer a 401(k), in addition to the ESOP, in certain circumstances.
We serve a 100 percent ESOP-owned company that pays no federal income taxes because it is taxed as an S corporation. Because the income is allocated to the nontaxable trust that owns the shares, it is exempt from paying federal income tax. A portion of the tax savings leads to higher compensation for employees and a larger amount of profits available to distribute to the trust, which enhances the value of each eligible employee’s retirement.
Do you have any final words of advice?
An ESOP can be a tremendous opportunity and one that I recommend to clients for tax savings and as part of a succession plan. However, it’s not right for every business. Working with an accountant who is a trusted adviser who knows a business owner’s long-term goals, both for the business and personal retirement, is crucial to evaluating this opportunity.
Bill Norwalk is a tax partner at Sensiba San Filippo LLP. Reach him at (925) 271-8700 or [email protected].
