If you own a closely held corporation and are approaching retirement or considering succession, an employee stock ownership plan (ESOP) may help you balance several potentially competing goals for your business.
An ESOP can provide a market for a departing owner’s interest in a closely held business while also creating an ownership benefit for employees. For some owners, it can provide an alternative to selling the company to an outside buyer.
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 aren’t ready to let go just yet, there may be tax advantages to transferring ownership sooner rather than later.
An ESOP is only one potential path. Business owners considering succession should evaluate it as part of a broader business exit plan that considers ownership transition, taxes, valuation, management succession, and personal financial objectives.
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 may allow an owner to transition ownership over time rather than sell the business outright to an outside buyer.
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 to take advantage of this strategy. Because changing entity structure can have significant tax and legal implications, business owners should evaluate that decision with their tax and legal advisors.
An ESOP also provides employees with an opportunity 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 accordance with the plan’s distribution provisions.
If your company is closely held, employees who receive stock must generally 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 and subject to qualification, participation, contribution, distribution, and fiduciary requirements.
ESOPs are also 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. Participants who receive distributions in stock may also have the right to sell their shares back to the company for fair market value.
This requirement can create a substantial future repurchase obligation that the company needs to anticipate and plan for.
Because an ESOP is a qualified employee benefit plan, ongoing compliance and administration should be considered alongside the transaction itself. LBMC provides employee benefit plan audit services for organizations subject to applicable plan audit requirements.
Tax Benefits of ESOPs
The potential advantages for business owners can be significant.
By selling some of your company stock to an ESOP, you may achieve greater liquidity, diversification, and financial security while creating a transition path for the business.
For qualifying C corporation transactions, a business owner may also be able to defer recognition of capital gain from the sale of stock to an ESOP if specific ownership, reinvestment, and other requirements are satisfied.
Because these requirements are technical and the tax consequences depend on the transaction, business owners should work with qualified tax and legal advisors before pursuing this strategy.
ESOPs can also permit a company to finance a buyout with borrowed funds. In a leveraged ESOP, the company makes contributions to the ESOP that can be used to repay acquisition debt, potentially creating meaningful tax and cash-flow advantages.
Another potential advantage of an ESOP over some other exit strategies is that it can allow business owners to transition ownership without immediately walking away from the company.
Depending on the transaction and governance structure, an owner may continue to play an active role in the business while ownership transitions over time.
That’s particularly important because ownership succession and management succession are not necessarily the same thing. Even with an ownership transition strategy in place, companies need leaders capable of running the business. For more on that process, see How to Groom Key Business Successors.
ESOPs may also have estate and financial planning implications. Selling shares to the plan can provide an owner with liquid assets while allowing the business itself to continue under a new ownership structure.
ESOP Benefits for S Corporations
ESOPs can also provide significant benefits for S corporations.
Tying the value of the ESOP to the company’s stock gives employees an opportunity to participate financially in the company’s future growth. Company contributions to an ESOP may also provide tax benefits, depending on the structure of the plan and transaction.
One of the most significant potential benefits involves the ESOP’s ownership interest in an S corporation. Because an ESOP is a tax-exempt qualified retirement plan, the portion of S corporation income attributable to the ESOP generally is not subject to federal income tax at the shareholder level.
For a 100% ESOP-owned S corporation, this can create a significant cash-flow advantage.
However, S corporation ESOPs have their own tax rules and limitations. For example, the capital gain deferral potentially available to qualifying shareholders selling C corporation stock to an ESOP generally is not available for sales of S corporation stock.
The differences between C corporation and S corporation ESOPs make transaction structure an important part of the planning process.
Cost Considerations of ESOPs
ESOPs are not the right exit strategy for every business.
Costs can include independent valuations, plan administration, professional advisory fees, financing costs, and future stock repurchase obligations. A company also needs to consider whether its cash flow can support the transaction and ongoing ESOP obligations.
These costs should be evaluated against the potential tax benefits, succession objectives, employee benefits, and long-term goals of the owners.
Valuation is particularly important because an ESOP transaction involves establishing the fair market value of a closely held company’s stock. LBMC’s business valuation professionals assist business owners and organizations with valuation matters. The Business Valuation service is active in LBMC’s current site architecture.
Is an ESOP Right for Your Business Exit Strategy?
ESOPs can offer business owners significant financial, tax, succession, and employee benefits. But they’re complex, and the advantages and requirements can differ significantly depending on whether the company is structured as a C corporation or an S corporation.
The larger question is whether an ESOP supports your objectives as an owner and the long-term needs of the business.
Consider questions such as:
- When do you want to exit the business?
- Do you want to remain involved after the ownership transition?
- Is preserving the company’s independence important?
- Do you have family members or management successors who will continue running the business?
- How much liquidity do you need from the transaction?
- What is the business worth?
- Can the company’s cash flow support the ESOP transaction and future obligations?
- How does an ESOP compare with a third-party sale or other succession strategy?
Those questions should be considered as part of a comprehensive exit planning process rather than in isolation.
Business owners should consult with their tax, legal, financial, valuation, and benefits advisors to determine whether an ESOP is a viable option for the company and its employees.
Content originally provided by LBMC auditor Mark Blackburn.
