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.
What is the win for the company?
There is an increased probability of management continuity, significant cash flows available to finance the transaction through tax and other savings, and research shows that ESOP companies are more profitable than comparable non-ESOP companies.
Because the balances in employees’ ESOP accounts are primarily invested in the stock of the sponsoring employer, participating employees become beneficial owners of the company. If the company’s value increases, participating employees stand to directly gain through the resulting growth of their ESOP accounts. The more substantial an ownership stake the ESOP provides employees, the more motivated they may be to improve company performance.
What is the win for the employees?
ESOPs offer employees retirement benefits and an ownership stake in the company for which they work. Additionally, an ESOP rewards employees who have promoted the employer’s success, and it can be structured to allow management to have effective control of the company, and possibly actual control over time, without risking their own capital. Also, tax savings significantly increase the long-term value of the stock.
What is the win for the selling shareholder?
ESOPs also offer a ready market to shareholders even in those cases in which a non-ESOP buyer may not exist at the time or when the owner only wishes to sell a portion of his or her stock. ESOPs can pay up to the fair market value of the shares, as determined by a qualified independent appraiser. For some industries, it can be difficult to get a fair price for the company based on its financial performance. An ESOP can help unlock this value for the selling shareholder(s). Thus, ESOPs give owners maximum flexibility over the size of the transaction, the timing of the sale and the price of the shares.
When selling to an ESOP, the selling shareholder(s) can preserve the company’s legacy and, with proper structuring, the selling shareholder(s) can retain effective control of the company even if the ESOP holds a majority of the stock.
Why have you not heard about ESOPs before from your advisers?
To achieve any or all of these benefits, companies and selling shareholders must carefully structure the ESOP transaction. After the transaction, the company must make sure that the ongoing operation of the ESOP adheres to the requirements of the Internal Revenue Code and the Employee Retirement Income Security Act of 1974 (ERISA).
The challenge is that many tax and other business advisers don’t have the ESOP experience needed to properly advise companies through the requirements. It is important to have experienced professionals guide you through an ESOP alternative.
Under U.S. Treasury rules issued in 2005, we must inform you that any advice in this communication to you was not intended or written to be used, and cannot be used, to avoid any government penalties that may be imposed on a taxpayer.
Hugh Reynolds is a partner with Crowe Horwath LLP. Reach him at (954) 202-8616 or email@example.com.