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ESOPs Offer Business Owners Tax-Efficient Exit Strategy

11/20/2018  |  By: Mark Blackburn, CPA, Shareholder, Audit and Advisory

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If you own a closely held corporation and are approaching retirement age, employee stock ownership plans (ESOPs) may help you balance conflicting goals for your business.

The National Center for Employee Ownership currently estimates that there are about 7,000 Employee Stock Ownership Plans (ESOPs) covering about 14 million employees in the United States. Roughly two-thirds of companies offer ESOPs to provide a market for a departing owner’s interest in a closely held business. Others may serve as a supplemental employee benefit plan or a mechanism to borrow money under favorable tax rules.

It is common for departing owners to tap at least some of the value of their business to fund their retirement. However, business owners may also wish to preserve their company for their children, employees and community. Even if you’re aren’t ready to let go just yet, there can be tax advantages to transferring ownership sooner rather than later.

How Do ESOPs Work?

An ESOP is a type of retirement plan that invests primarily in the company’s own stock. Instead of investing in publicly traded stocks, bonds and mutual funds, an ESOP is designed to invest in company stock. The employer makes tax-deductible contributions to the ESOP, which the plan uses to acquire stock from the company or its owners. Essentially, an ESOP provides a “buyer” for the company’s shares. Like other qualified plans, it’s subject to rules and restrictions, including contribution limits and coverage requirements. Unlike other plans, however, ESOPs must obtain annual independent appraisals of their stock.

ESOPs can provide a tax-efficient exit strategy that allows you to remain in control until you’re fully ready to retire. ESOPs are available only to corporations. If your business is organized as a sole proprietorship, partnership or limited liability company (LLC), you’ll have to convert it into corporate form (a potentially complicated proposition) to take advantage of this strategy.

An ESOP provides a powerful incentive for employees to share in the company’s growth on a tax-deferred basis. When employees retire or otherwise qualify for distributions from the plan, they receive the vested portion of their ESOP account balance in the form of stock or cash. If your company is closely held, employees who receive stock must be given a “put option” — the right to sell the stock back to the company during specified time windows at fair market value.

Administrative Guidelines for ESOPs

Like other qualified plans, ESOPs are strictly regulated. They must cover all full-time employees who meet certain age and service requirements, and they’re subject to annual contribution limits (generally 25% of covered compensation), among other conditions.

ESOPs are subject to rules that don’t apply to other types of qualified retirement plans. For example, an ESOP must obtain an independent appraisal of the company’s stock when the plan is established and at least annually thereafter. Also, participants who receive distributions in stock must be given the right to sell their shares back to the company for fair market value. This requirement creates a substantial repurchase liability that the company must prepare for.

Tax Benefits of ESOPs

The advantages for business owners are significant. By selling some of your company stock to an ESOP, you achieve greater liquidity, diversification and financial security. If your company is a C corporation and the ESOP acquires at least 30% of its stock, you can defer any taxable capital gains on the sale of the shares indefinitely by reinvesting the proceeds in certain qualified replacement property within one year after the sale. Qualified replacement property includes most securities issued by domestic operating companies.

ESOPs also permit a company to finance a buyout with borrowed funds. A “leveraged” ESOP essentially permits the company to deduct the interest and the principal on loans used to make ESOP contributions — a tax benefit that can-do wonders for cash flow. The company can also deduct certain dividends paid on ESOP shares. Interest and dividend payments don’t count against contribution limits.

Another advantage of ESOPs over other exit strategies is that they allow business owners to cash out without giving up control over the business. Even if owners transfer a controlling interest to an ESOP, most day-to-day decisions will be made by the ESOP’s trustee, who can be a company officer. You can continue to serve as your company’s CEO and, as a trustee of the ESOP trust, vote on most corporate decisions. However, ESOP participants may have the right to vote on major decisions, such as a merger or sale of substantially all the company’s assets.

ESOPs also make sense from an estate planning perspective. Selling shares to your company’s plan provides you with liquid assets to distribute to children or other family members who aren’t involved in the business. At the same time, you can hold on to enough stock to transfer control of the business to those who are involved.

ESOP Benefits for S Corporations

Tying the value of the ESOP to your company’s stock gives employees a powerful incentive to work hard for the business’s future. Company contributions to the ESOP that are used to acquire your stock are tax-deductible, and the company can even borrow the funds it needs — essentially allowing it to deduct both interest and principal payments on the loan.

If your company is structured as an S corporation, the ESOP’s allocable share of its income is exempt from federal income taxes. A similar exemption is available in most states. This means that an S corporation owned 100% by an ESOP can avoid federal income taxes, and often state income taxes. However, keep in mind that S corporation ESOPs present certain tax disadvantages as well, such as preventing owners from deferring gains on shares sold to the ESOP.

Cost Concerns of ESOPs

ESOP costs can add up, including the expense of annual appraisals, stock repurchase obligations, loan payments and qualified plan administration. Weigh such costs with your advisors before adopting this strategy. In addition, tax reform could potentially affect ESOP and estate planning strategies.

Who can answer questions about ESOPs?

ESOPs offer numerous financial upsides. But there are some significant differences in the rules for administering ESOPs, depending on whether the company is set up as a C corporation or an S corporation.

Consult with your tax, legal and benefits advisors to decide whether an ESOP is a viable option for you and your employees.

Are you ready to start a conversation?