An Employee Stock Ownership Plan (ESOP) is a Tax-Smart Business Strategy

Written by: Scott A. Bishop, MBA, CPA/PFS, CFP®

As the baby boom generation of business owners approaches retirement, more and more are interested in selling or otherwise cashing out of their businesses.

In the 1990s this could have been accomplished through roll-ups, initial public offerings or sales to industry consolidators. However, in the post-9/11, post -Sarbanes Oxley, and “post-tech bubble” world, more business owners are turning to a time-tested strategy of selling their businesses by “going public, privately” through the use of an employee stock ownership plan (ESOP).

By utilizing an ESOP, business owners can create significant income tax advantages for both themselves and their companies while allowing them to diversify part or their entire stake in their company. All this and the doors stay open, the employees keep their jobs and the name stays on the door. ls it any wonder that ESOPs are enjoying a resurgence in usage?

Many business owners are unfamiliar with ESOPs, even though they’ve been around in essentially their current form for over 20 years. ESOPs are remarkably flexible plans that permit business owners to accomplish a variety of business and personal financial planning objectives.

For example, ESOPs may serve the company as a means of corporate finance to fuel growth, to increase capital available to purchase fixed assets such as buildings or equipment, or to acquire the stock from retiring or disinterested shareholders.

Since ESOP stock must be valued by an independent appraiser each year, disputes involving the valuation of the company’s stock may be minimized and firm values may be established for planning and financing purposes.

If the company’s objective is to minimize income taxes, an ESOP is an excellent tool that may be used to create tax deductions of up to 25 percent of the company’s payroll plus any interest incurred by the ESOP for the acquisition of the sponsor company’s stock.

Often, the objective of the business owner who is selling his business is to minimize the size of the check that he writes to the IRS for capital gains taxes upon the sale of the business. (Currently, the capital gains are taxed at a maximum of 15 percent of the gain, but the tax percentage increases back to 20 percent in 2009.) The sale to an ESOP, properly arranged, can result in postponing and potentially eliminating capital gains taxes on the entire transaction.

Beyond the company’s purely financial and tax motivations, an ESOP may be a cost-effective way to motivate employees and to boost productivity by giving each employee a stake in the future performance of the company through employee stock ownership. And this benefit is gained without surrendering the control of the day-to­ day decision making by the business owner.

Setting Up A Plan
An ESOP is a tax-qualified employee retirement benefit plan like a pension or a profit-sharing plan. The employer establishes a plan, names a trustee and funds the plan initially with cash.

What makes the ESOP unique is that the plan is designed to own stock in its sponsoring company. Therefore, future employer contributions may be in cash (which can be borrowed from a bank) with which the ESOP may use to acquire stock. Future contributions may also be in company stock.

Stock contributions have the effect of creating a tax deduction without expending the company’s cash.

The plan trustee holds the stock for the benefit of the employees who participate in the ESOP. As participating employees approach retirement age, they are given the right to convert their ownership of stock to investable securities or to receive their retirement benefits in stock.

Postponing Capital Gains Taxes
An owner of a C-corporation can defer capital gains taxes indefinitely on the sale of company stock to an ESOP by taking advantage of a Section 1042 rollover, Section 1042 of the Internal Revenue Code permits owners to defer capital gains taxes on the sale of company stock to an ESOP — if the sales proceeds are
reinvested in qualifying replacement securities within a set time frame (subject to several other technical requirements).

If the owner chooses to sell the replacement securities, substantial capital gains taxes may be incurred. However, if the replacement securities are still in the owner’s portfolio at the time of his death, the deferred gain escapes capital gains taxes permanently. (This tax break will be limited in 2010, the year the federal estate tax is repealed.)

Thus, by selling to an ESOP, the owner of a closely held business can obtain liquidity for all or a part of his ownership interest. Therefore, instead of having the bulk of his personal wealth tied up in the fortunes of just one company, the owner can use the proceeds from the sale to invest in a well-diversified portfolio of securities.

ESOPs are Not for Everyone
ESOPs are not a panacea. They do have some disadvantages.

The first is the expense of establishing and maintaining the ESOP. Because ESOPs are still a relatively unique form of retirement plan, the costs of creating the plan documents and the ongoing expenses are much more expensive than those of a traditional profit-sharing plan or pension. Adding to the administrative expense is the cost of an annual business valuation; these costs can be as much as $10,000 or more.

A second concern is financial. While the many advantages of ESOP transactions should facilitate the financing and acquisition of the owner’s stock, the ESOP structure may complicate critical negotiations with lenders who are unaware or are unfamiliar with the application and advantages of financing through an ESOP.

Lastly, ESOPs are often touted and wonderful tools to increase employee spirit and productivity. While several studies have indicated this to be true, it is almost impossible to conclude that increases in productivity were caused exclusively by the ESOP.

To know what is right for him, a person can contract with someone with ESOP expertise to conduct a feasibility study to determine how an ESOP might apply in his given fact pattern. The study should consider the value of the company, the demographics of employees, the financial future of the company and its industry, the goals and objectives of both current and future ownership, the current and projected cash flow and the income tax situation of the company.

In reviewing the study, the owner should then be able to decide whether to implement or forgo the ESOP as a prudent solution.

When an ESOP is right, it is an incredibly tax efficient, financially sound tool that can help assure the timely, successful transition of business ownership.

© 2005 American City Business Journals Inc.

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