Using ESOPs to minimize taxes Featured

9:57am EDT June 30, 2006
In today’s competitive business environment, no company can afford to have uninterested, unproductive workers on its team. And while some firms opt for incentive programs and other perks to keep employees motivated and productive, others have found the answer in an innovative ownership structure known as an “ESOP,” or employee stock ownership plan.

At their simplest, ESOPs are tax-qualified, deferred-compensation benefits that make the employees of a firm the beneficial owners of its stock. ESOPs are unique in that they’re the only corporate entities required under U.S. tax and labor laws to invest primarily in the securities of the sponsoring employer. They’re also the only employee retirement savings plan that may use borrowed funds to acquire its asset, the employer securities.

“We’ve seen a major increase in the number of companies interested in forming ESOPs,” says Glenn Gelman, managing director at Glenn M. Gelman & Associates CPAs. “They not only provide significant tax benefits, but they also serve as an effective management tool, helping companies motivate their workforces to higher levels of productivity.”

To help, Smart Business spoke with Gelman about the tax benefits of ESOPs and how companies can take advantage of them.

What’s driving the growth of ESOPs?
In 2000, the IRS ruled that S-Corporations owned by ESOPs are essentially free of federal taxation. That increased significantly the number of firms interested in doing 100 percent ESOPs within their S-Corporations. Today, literally thousands of companies nationwide are ESOP-owned.

Currently, about 11,000 ESOPs are in place in the U.S. (up from 5,000 in 1987), covering 10 million employees, or 10 percent of the private sector work force. These employees draw in excess of 3 percent of their total compensation from ESOP contributions.

According to the ESOP Association, about 7 percent are publicly traded companies, and 25 percent are in the manufacturing sector, followed closely by construction and distribution.

What tax benefits can a company expect from an ESOP?
An ESOP plan is a form of a defined benefit pension plan, with the major difference being that the only investment that the pension plan can have is the stock of the employer. That makes an ESOP different than any other pension plan, and the tax benefit is tremendous because the seller of the shares (or the majority shareholders) can defer the gain on the sale of their shares to the ESOP by rolling over the proceeds into domestic securities.

Many times these shareholders are older, and should they continue to hold the replacement property indefinitely, when they pass away that replacement product would get stepped up in basis. At that point, there would be no income tax whatsoever on the transaction. If the owner sells 100 percent of his or her shares to the ESOP, and if an S-Corporation selection is made, then that selection creates a non-taxable environment that the company can operate in forever.

What does a company need to think about before forming an ESOP?
For starters, it would need to be a very profitable company that is seeking tax benefits as well as an exit strategy for the owner. The ideal ESOP candidate should have multiple employees and an owner who is looking for a long-term (as opposed to short-term) exit strategy.

How can a company introduce the concept to employees?
Employee education is critical to the ESOP’s long-term success. Tax advantages aside, another byproduct of an ESOP is that employees feel involved and think like company owners. As a result, they tend to save money and they are more careful in everything they do. They take on an entirely different level of ownership and attitudes about the products/services. They also pay more attention to their individual performance. This kind of buy-in can be a double-edged sword for the employer, who must keep those workers informed or risk having them feel left out.

How should a company launch an ESOP strategy?
It first needs to determine the value of the business by relying on a company that’s familiar with ESOPs and that handles business valuations. From this exercise, one should be able to determine hypothetically how much money the shareholders could get through the sale to an ESOP. If that money is ample — given the fact that it would be tax deferred and potentially tax free — and if it’s more money than the company could get by selling to a competitor or to an outside party — then owners should consider whether they would come out ahead in the long run by instituting an ESOP. Another benefit of selling to an ESOP is that owners need not disclose confidential information to a potential buyer who could turn around and use it to compete against you.

GLENN GELMAN is managing director at Glenn M. Gelman & Associates CPAs in Santa Ana, Calif. Reach him at (714) 667-2600 or ggel@gmgcpa.com.