Is an ESOP Right for Your Business?

How much of your net worth is tied up in your business? If it represents a large percentage, you may have wondered how you can transfer this wealth to the next generation of entrepreneurs, while attracting, rewarding and retaining valuable employees.

Employee ownership is booming and can be accomplished in a variety of ways:

• You can give shares to them as a bonus.
• They can receive stock options.
• They can get stock through a profit-sharing plan.
• Employees can buy your company's stock directly, through employee stock ownership plans (ESOPs).

In addition, according to the NationalCenter for Employee Ownership, a trade group in Washington, D.C., the number of business owners implementing ESOPs has surged since 1975.

Source: https://www.nceo.org/library/eo_stat.html

An ESOP will let you implement a plan for employees to acquire some or all of your company's stock and, because an ESOP is a retirement plan, you and your employees will get tax benefits that are not available with other buy/sell strategies. (For more insight, read about how to avoid Enron-esque retirement plans and more.)

Your company can reap some great federal income tax breaks with ESOPs, including:

• Deductible ESOP contributions: Discretionary, corporate annual cash contributions to the ESOP are deductible on up to 25% of the pay of plan participants.
• Deductible principal and interest payments: Whenever the ESOP borrows money to buy your shares, your business can make tax-deductible contributions to the plan, to repay the loan. Contributions to repay principal are deductible on up to 25% of the plan participants' payroll, however, interest is always deductible.
• Tax-free earnings: ESOPs do not pay federal income tax. In addition, your employees won't pay income tax on stock put into their ESOP accounts, until they take distributions. If they take distributions prior to age 59.5, they'll have to pay a 10% penalty in addition to the income tax, but they can roll the money into an IRA or another qualified plan, and continue the tax deferral.

Furthermore, if you own a C-corporation and sell 30% or more of your stock to the ESOP, you can defer, or maybe even avoid, the capital gains tax. However, you must reinvest the sales proceeds into stocks, bonds or other securities of U.S. operating companies. Government bonds and mutual funds do not qualify.

An ESOP can be appealing if you want to reward employees who have helped you build your business, and it can also be used to supplement your firm's 401(k) or another retirement plan.

You can ask yourself these questions:

• Do you worry about someone else running your company? An ESOP only makes the rank-and-file employees the beneficiaries of a plan that holds stock in their names. Yes, they'll have voting rights, but a board of directors will still exist and managers will still manage. (For more insight, read up on your rights as a shareholder.)
• Is your company profitable? If so, an ESOP will be advantageous from a tax perspective, because you're currently paying taxes on earnings. If your company does not have a history of profitability, the trustee might object to the ESOP buying the stock.
• Which employees are you willing to include? Although there are some exceptions, generally all full-time employees over 21 must be able to participate in the plan.

To set up an ESOP, you'll have to establish a trust to buy your stock. Then, each year you'll make tax-deductible contributions of company shares, cash for the ESOP to buy company shares, or both.

The ESOP trust will own the stock and allocate shares to individual employee's accounts. Allocations are based on the employee's pay or some more equal formula. As employees accumulate seniority with your company, they acquire an increasing right to the shares in their account; a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradually.

Employees get the stock after they leave your company. At that point, the company must offer to buy the shares back, unless there is a public market for them. In non-publicly traded companies, the share price cannot exceed its fair market value, as set by an independent appraiser.

Frequently, companies must obtain financing to buy the owner's shares. In such cases, the ESOP borrows money based on the company's credit. The company then makes contributions to the plan, to repay the loan.

Don't expect to make a killing on the stock you sell to an ESOP; it probably won't be as much as you might receive by selling the company outright or taking it public. The ESOP must pay no more than fair market value for your company's shares, and if your stock is not a publicly-traded security, the value is determined by an independent valuation expert.

Valuations are based on a number of factors and may include a premium if the ESOP buys a controlling interest in your business. On the other hand, the value might be discounted when there is a lack of marketability because the stock is not publicly traded.

ESOPs do have a few drawbacks. For one, you can only use an ESOP in C- or S-corporations, not partnerships or most professional corporations. Also, because private companies must repurchase a departing employee's shares, you could face a major expense in the future, if a large number of workers quit or retire at the same time. Furthermore, the cost of setting up an ESOP is substantial, perhaps $40,000 for the simplest of plans in small companies. Moreover, any time your company issues new shares, the stock of existing owners is diluted. (For other plans, read about how to set up a SEP IRA.)

Despite the highs and the lows, the important point to remember is that ESOPs can help you establish a transition plan for your business by creating a market for your company's stock, allowing you to sell your business gradually instead of exiting suddenly, and providing an ownership culture within your company.