Business owners who are thinking about transitioning out of their businesses have to consider both the financial as well as non-financial implications of the path they choose to follow. Two of the most frequently mentioned owner concerns related to their transition include achieving their long-term retirement goals and making sure their employees will be taken care of. After all, they have depended on their employees to ensure the smooth operation of the business and want to reward them for their dedication and hard work. To achieve both of these objectives, owners may to consider an Employee Stock Ownership Plan (ESOP) as a viable ownership transition strategy.
ESOPs are actually a tax-qualified retirement plan that are similar to a profit-sharing plan, but are designed to be invested primarily in stock of the sponsoring employer. It allows for higher contributions and deduction limits than other qualified retirement plans.
An ESOP can be created when a sole owner or group of owners wants to sell all or a portion of their company’s shares to ALL of their employees. The major benefits of an ESOP include:
- Preferential tax treatment;
- All of the people who helped build the company are included;
- The owner also has the opportunity to keep control and transition out gradually while leaving in place people who know and care most about the future of the business;
- All employees share in the growth of the company stock; and
- It can be an effective hiring and employee retention tool.
Contrary to the name, the Employee Stock Ownership Plan does not involve selling stock directly to each employee. It involves selling the owner’s shares to a trust for the benefit of all employees, while maintaining operational control. It provides the owner liquidity, a built-in buyer, and some great tax advantages. If the employees stay with the company, their hard work will pay off in the form of company stock that is distributed annually to an individual retirement account based on their level of compensation. Employees will vest into the ESOP over time and their shares will be purchased by the company when they leave at a future date.
ESOPs are often funded with third-party (i.e., bank) debt, but may also require owner financing. For the most part, these types of transfers are done at a lower selling price than the external sale but could actually net the owner more money due to the minimization of taxes. For example, S Corporations owned by ESOPs pay no income taxes, and owners of C corporation stock are able to defer paying capital gains tax if the net proceeds are placed in certain types of investments.
These types of transfers are often thought of as being appropriate only for the largest companies, but this isn’t the case. Generally a minimum of 15 to 20 employees is required. However, there are certain other characteristics that determine whether a company is a good candidate for an ESOP. We will discuss these in a later article.
The National Center for Employee Ownership reports that as of 2014, the most recent year for which data is available, there were 6,717 ESOPs in the United States, holding total assets of more than $1.3 trillion. These plans cover close to 14 million participants, of whom 10.6 million are active participants—those currently employed and covered by an ESOP.
With the proper planning, an ESOP can be an attractive business transition option for owners. It enables the current owners to retain control while providing ownership for the employees, liquidity to fund their retirement, and most of all, significant tax savings. However, developing an ESOP takes significant time, expertise, and money.
During the coming weeks, we’ll be discussing the types of companies that are good candidates for ESOPs, pitfalls to avoid and what owners need to consider before embarking on this path.