Every employee wants to know if he or she will be able to retire comfortably. But, there are many retirement plans out there, and navigating them can be cumbersome and time-consuming. Because of this, many companies shoulder the burden for their employees, offering various options designed to prepare employees for their golden years.
One such plan is the Employee Stock Ownership Plan (ESOP), which is similar to a stock bonus plan or money purchase plan. ESOPs are intended to invest first and foremost in the employer’s stock, instead of mutual funds or publicly traded stock, according to Rene Lozano, CPA, a manager in the tax department at Briggs & Veselka Co. Essentially, these plans are set up to purchase stock from the private company owner.
“ESOPs were created by Congress in 1974 to help supplement retiree income,” Lozano says. “Since that time, these plans have been used by the likes of Microsoft and General Electric. They can be very beneficial to both employees and employers.”
Smart Business spoke with Lozano about ESOPs and how companies can utilize them to ensure prosperous futures.
What are the benefits of ESOPs?
ESOPs have a number of benefits. First and foremost are the tax benefits. A plan can also help a business owner diversify his or her investment. And ESOPs can even help increase employee productivity and retention.
The owner of a private company can defer the gain on the sale of his or her stock to the ESOP if he or she sells at least 30 percent and the corporation is not classified as an S corporation. To defer the gain, the seller will also have to reinvest the proceeds in other stocks or bonds. As an added benefit, the owner of the private company is diversifying his or her investment in other stocks or bonds.
The company will also be able to take a tax deduction of up to 25 percent of eligible employee wages when the company contributes to the plan. If the company is an S corporation it will not have to pay any federal income taxes on the ESOP’s share of the company’s profits. In fact, a 100 percent ESOP-owned S corporation will not pay any federal income taxes on company profits. The reduction in taxes generally helps to increase cash flow and is often used to help pay for the ESOP contributions.
ESOPs give employees a direct stake in their own output. This connection helps to increase employees’ productivity, and they are also more likely to control costs and reduce misconduct.
What problems or issues can arise from ESOPs?
Owners of private companies with S corporation status are not eligible for the tax-free rollover when they sell their shares to an ESOP. This can be avoided by converting into a C corporation; unfortunately, the change will cause the company to pay corporate income taxes for at least the next five years. A company will also not be able to deduct more than 25 percent of eligible employee wages to the ESOP. So, any portion of contributions made in excess of the 25 percent is not deductible by the company.
How can the problems be solved?
Most or all issues related to an ESOP can and should be avoided with proper planning. Excess nondeductible contributions can be avoided in this way. The owner can also avoid taxes on the sale by reinvesting the proceeds.
What are the consequences a company faces?
ESOPs have the ability to take out loans to purchase company stock. A loan may not be the proper course of action if the company is not profitable enough to make loan payments and repurchase shares from employees retiring or leaving the company.
What is the resolution to all this?
ESOPs can and should be used as a tool to help private owners and their companies in a variety of ways. A properly executed ESOP will benefit the owner and the company. The owner has the ability to retain control of the company in a sale. A seller of less than the entire company will often find himself owning a smaller share of a larger company. And, employee ownership will also help to increase productivity while increasing overall company value.
RENE LOZANO, CPA, is a manager in the tax department at Briggs & Veselka Co. in Houston. Reach him at (713) 667-9147 or firstname.lastname@example.org.