ESOPs are a qualified benefit plan under ERISA. They offer a benefit to employers and several tax advantages for the selling shareholders. There are disadvantages as well. For example, they might be too expensive for small companies or for businesses whose payrolls are too small relative to the value of the owners’ interests. And they generally will not be right for start-up companies. Nevertheless, ESOPs are fairly common in the corporate world. Nationally, according to the National Center for Employee Ownership, there exist approximately 9,000 ESOP and/or similar plans.
Smart Business spoke with Garry Karch of MB Financial Bank to learn more about the advantages of ESOPs and who they benefit.
Why would a business owner consider an ESOP?
The goal is to establish a form of employee ownership through which the business sells stock to an employee trust. It is a somewhat complex process, which benefits both business owners and employees. One reason is altruistic, while the other is financially driven.
From the financial perspective, there can be some fairly significant tax benefits to the selling shareholder. If the company is a C corporation, sellers who are willing to reinvest the proceeds from the sale can defer the capital gains taxes on them when they are reinvested into a qualified replacement property (QRP).
A QRP is an equity or debt instrument of a domestic operating company. It can be public or private, but it can’t be treasuries, ‘munis,’ mutual funds, or that type of thing. If sellers reinvest those proceeds, they can defer the capital gains tax. And, if the sellers hold the proceeds until their deaths, they pass on to their heirs on a stepped-up basis. So, in a way, an ESOP can be a strategic part of a business owner’s wealth management and succession programs.
Altruistically, there are some selling shareholders who really want to reward the efforts of the employees who have made the company successful, and they want to assure its continuity. In a lot of cases, they prefer to do so through the ESOP mechanism, rather than sell to a financial or strategic buyer who may or may not be concerned with retaining jobs and keeping the company going on an independent basis. In essence, the employees get an ownership stake in a company and build up a retirement fund without making a contribution in return for it.
What significant tax benefit accrues to employees and shareholders in setting up an ESOP?
One major benefit is associated with the principal on the ESOP loan. Here is where ESOPs can get a bit complex. The principal payments on the loan are generally going to be made using pre-tax dollars. They are structured where the dollar amount is contributed to the trust. This portion of the overall principal payment is deductible as a business expense, and the employee accounts receive allocations used in the contribution.
Does the entire company have to be sold to set up an ESOP?
The shareholder does not have to do a 100 percent transaction. Basically, if the business is a C corporation and the shareholder is looking to defer the capital gains tax, he must sell at least 30 percent in the first stage of an overall transaction, which is the threshold under the regulations to get a capital gains tax deferral. In a lot of cases, the seller won’t necessarily be able to do a 100 percent transaction, at least without taking back a note. A bank can only loan so much money to a company. Realistically, a lot of ESOPs are set up in two stages.
What is a bank’s role in setting up an ESOP?
The bank’s role is to help set up the overall financing structure in conjunction with the business owner or a financial adviser he might retain to put the deal together. But not all banks get involved with ESOPs. As a matter of fact, only a handful locally or nationally do. Business owners who are considering setting up ESOPs are wise to choose banks that have considerable experience in the area, and which are willing to work with attorneys, financial advisers, and other specialists who become involved in the process.
GARRY KARCH is the Commercial Group regional president with MB Financial Bank. Reach him at (312) 456-8520 or email@example.com.