The Benefits of an ESOP in Your Transition Plan
Choosing an exit strategy from your successful company can be difficult. Though options abound, one many fail to consider is an employee stock ownership plan, or ESOP. This type of plan can have outstanding benefits for both employees and owners.
What Are ESOPs?
Much like a 401(k) or profit-sharing plan, ESOPs are considered a tax-qualified retirement plan subject to Employee Retirement Income Security Act of 1974 (ERISA) requirements. The biggest difference is that an ESOP has to invest in the business’s stock. It provides a great option to reward employees that have been loyal while transferring ownership to them.
ESOPs work well for small to midsize companies with under 250 employees and sales averaging $20 million-$50 million annually. There are about 6,500 ESOPs in the United States covering 14 million employees.
How Do They Work?
The ESOP trust must be formed by the company, with a trustee who is typically independent of the business. All or a portion of the company is purchased by the ESOP from the owner(s) following an appraisal. In many cases, money must be borrowed from an outside lender by the business, with the proceeds from the loan immediately distributed to the ESOP as an internal loan. This allows the ESOP to immediately purchase the interest or shares in the business. This must happen in a two-step process so your outside lender can avoid compliance problems with ERISA loan requirements.
If the purchase is only partially financed from outside sources, the seller or owner can fund the remaining interest using seller or owner notes calling for a reasonable interest rate while remaining subordinate to the outside financing. Because this form of funding the ESOP provides a favorable rate of return, many owners find this type of financing appealing due to the extra income off of the interest.
Much like how a business makes contributions to a 401(k), the company will have to make tax-deductible contributions annually to the ESOP. That contribution gives the ESOP funds to repay the loan it has in place with the business itself. However, beyond the required tax-deductible contributions made to the ESOP, C corporations can pay a tax-deductible dividend. S corporations can make distributions on stock shares being held by the ESOP to help pay down the internal loan.
While the ESOP pays down the internal loan to the business, the shares purchased by it are kept in an account within the trust. As the loan is paid down, shares of stock are released from this account to be allocated to employee accounts of those participating in the ESOP.
Employee participation can be based on the number of years of service the employee has or in other ways. The greater the employee participation in the business, the greater their participation will be in the ESOP. Though rules vary, employees are typically fully vested in three to six years.
ESOPs are a great way to create internal markets for interest or shares in the business. This in turn gives the departing owner an option for liquidity. They provide a range of tax incentives and tax deductions, with the owner able to defer the transaction’s taxes in many cases. Shareholders in a C corporation can defer taxes by reinvesting proceeds into the securities of outside domestic companies. S corporations and partnerships may be changed into a C corporation prior to the sale for the same tax deferral benefits.
However, if the company remains an S corporation, federal taxes are not paid on the shares held by the ESOP due to pass-through rules. Employee shares held by the ESOP trust continue to grow (even while in the employee accounts) but remain tax-free until they’re disbursed.
ESOP-owned businesses also keep their culture post sale and retain employees for longer periods. They also align the employees’ and owner’s interests. Having a stake in the business motivates employees to be accountable and improve profitability.
But there’s a downside, right?
Well… yes, a few. First, setting up an ESOP is an expensive proposition. Establishing the plan and handling the sale of the stock requires specific expertise and takes time. So attorneys, third-party administrators, financial institutions and other additional parties are often involved in the transition.
They’re also complicated to maintain. After ESOP participants reach age 55 and have participated in the plan for ten years, they have the right during the following five years to diversify up to a total of 25% of company stock acquired by the ESOP and allocated to their accounts. During the sixth year, they may diversify up to a total of 50%, minus any previously diversified shares.
To satisfy these diversification requirement, the ESOP must either offer at least three alternative investments under the ESOP (or another plan such as a 401(k) plan) or distribute cash or company stock to the participants.
Your company must also be profitable enough to make contributions. In a leveraged ESOP, the plan must make debt payments to the company based on the amortization schedule. In order for the ESOP to have the cash for those payments, the company must be able to make contributions to the ESOP for the plan to purchase the stock. And as participants leave the company, the value of the stock must be paid out as determined in the plan.
Finally, you’ll have less liquidity at the close of your company’s sale. The seller often takes a seller note for a portion of the selling price. This will likely be noticeably less than the final price of a third-party business sale.
Does an ESOP make sense for you?
You’ll have to take many considerations into account to ensure the ESOP you create will work for your business. This includes continuity of management, evaluations of preexisting debt, willingness of the owner to accept appraised fair market value for their shares, and the legal limitations on how much can be contributed to the ESOP every year.
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