You’ve worked hard to build your business, and now it’s time to think about the future. Don’t let yourself get backed into a corner and have to sell your business in a pinch. Why not consider selling it to your employees by setting up an Employee Stock Ownership Plan (ESOP)?
“Recent surveys indicate that some 60 percent of business owners lack a succession plan,” says Carl J. Grassi, president of McDonald Hopkins LLC. “That’s worrisome because it’s important to devote time and attention to building your graceful exit.”
An ESOP is a qualified retirement plan that allows you to sell your business to your employees. It is designed to invest primarily in the employer’s stock. ESOPs are often used as vehicles to obtain financing for the buyout of shares from existing shareholders on a tax-advantaged basis.
Smart Business asked Grassi why business owners should consider an ESOP.
How do you determine if an ESOP is the right fit for your business?
Ideally, an ESOP candidate is a corporation that has sufficient debt capacity; a history of dependable, positive cash flow, usually in a business that is not overly cyclical; a strong management team; and culture that promotes employee ownership. Also, it is important that the company have relatively low employee turnover and sufficient annual payroll to take advantage of the tax benefits associated with an ESOP.
How does the process begin?
The business should consider an ESOP feasibility study. The results of that study will help the company decide whether to proceed.
What are the tax incentives of an ESOP?
If, after the transaction, an ESOP owns at least 30 percent of the outstanding stock of the corporation, and proceeds received by selling shareholders are rolled over into ‘qualified replacement property,’ the federal income tax realized from the sale by a selling shareholder can generally be deferred — this tax benefit does not apply to an S corporation. The corporation will get a tax deduction for the interest paid to the lender and for an amount equal to the principal repayments, generally not in excess of 25 percent of the eligible compensation of ESOP participants. In an S corporation, whatever percentage an ESOP owns, that is generally the percentage of the company’s taxable income not subject to federal income tax.
How can a selling shareholder properly take advantage of the income tax deferral?
To take advantage of the income tax deferral, the proceeds received from the ESOP must be reinvested, generally within 12 months of the sale, in qualified replacement property, which I briefly mentioned. Qualified replacement property includes stock or securities generally issued by a domestic operating corporation. Reinvestment in shares of a mutual fund or government securities does not qualify as replacement property. Interest or dividend income on replacement securities will still be taxed when received. The gain previously deferred generally will be recognized when the replacement property is sold. Some shareholders may not be eligible for this income tax deferral treatment.
What are the benefits to other shareholders?
An ESOP may alleviate or limit the need for insurance on the selling shareholder’s life, establish the vehicle for future sales of additional stock of the corporation, and relieve remaining shareholders and the corporation from the requirement of buying out selling shareholders’ shares upon their death. Depending on the percentage of the ESOP’s ownership of the corporation, the remaining shareholders may still control the business.
What are the benefits to the corporation and employees?
The ESOP provides a tax-advantaged financing vehicle to buy out the stock of a selling shareholder. The effect of an ESOP transaction is that the interest and principal payments by the corporation on the bank loan to fund its loan to the ESOP are usually fully tax deductible. Accordingly, the corporation is able to fund the buyout of a selling shareholder with pretax dollars as opposed to after-tax dollars. For employees, an ESOP can provide a significant stock-based, incentive-oriented retirement plan benefit. Employees will share in the equity growth of the business.
What about potential drawbacks?
The shares sold to the ESOP must generally be held by the ESOP for three years to avoid an excise tax. ESOPs of S corporations that have relatively few participants are restricted in allocating stock or synthetic equity to certain persons. ESOPs may be too expensive for small companies. Setting up an ESOP is complex, and you have to take a close look at debt financing and all the various requirements related to the tax treatment.
CARL J. GRASSI is the president of McDonald Hopkins LLC. Reach him at (216) 348-5400 or firstname.lastname@example.org.