When you own a closely held company, and you start approaching retirement age, it’s easy to struggle with balancing conflicting goals for your business. In a case like this, an employee stock ownership plan (ESOP) may be the best answer.
Take a Closer Look
It’s common for business owners to have to tap at least a small portion of the value of their company to fund their retirement. It may also be their wish to preserve their company for their employees, their children, and the community in which they reside.
Transferring ownership as early as possible to the next generation of business owners can have considerable tax advantages. However, it can also further complicate matters. Not all owners are ready to walk away from the company that they built, even if from a tax perspective it may seem like the best decision.
Consider This Solution
When an owner is not quite ready to walk away from their business, this is where an ESOP can become beneficial to business owners. This type of plan gives business owners an exit strategy that is tax-efficient and allows them to remain in control until they are completely ready to retire. It is important to note that ESOPs are only available to corporations. In order for any business that is organized as a partnership, sole proprietorship, or a limited liability company (LLC) to take advantage of this strategy, they would need to convert to a corporate form—a proposition with potential consequences.
An ESOP is a type of qualified retirement plan. It is designed to invest predominately in your company’s stock, instead of publicly traded stocks, bonds, or mutual funds. Similar to other qualified plans, an ESOP is still subject to its own rules and restrictions, like coverage requirements and limits on how much you are able to contribute. However, they must obtain annual independent appraisals of their stocks, which differentiates them from other plans.
When an employee becomes eligible for benefits, they will typically receive a vested part of their ESOP account balance in the form of either stock or cash. If your business is considered closely-held, any employees who receive stock must be given the right to sell their stock back to the company at fair market value during a specified time, otherwise known as a “put option.”
Calculate the Potential Benefits
The advantages of an ESOP for the owners of a closely-held company are remarkable. When you consider selling some of your company stock to an ESOP, you have a greater chance of achieving higher liquidity, financial security, and diversification of your assets. Furthermore, if your company is a C corporation and the ESOP acquires 30% of its stock, by reinvesting the proceeds in certain qualified securities, you have the ability to defer taxable capital gains.
Not to worry, giving up ownership to an ESOP does not necessarily mean giving up control—at least not immediately. You have the option to continue serving as the company’s CEO, as a trustee of the ESOP trust, and continue voting on most corporate decisions.
From the perspective of estate planning, an ESOP also makes a great deal of sense for a company owner. By selling shares to your company’s plan, you are provided with liquid assets that are distributable to other family members that may not be directly involved in the business.
Simultaneously, you can still hold enough stock so that you can transfer control of your business to chosen individuals who are involved.
When the value of the ESOP ties to the company’s stock, employees are given a strong incentive to work hard for the success of the future of the business. Did you know that company contributions to the ESOP that are used to acquire stock are tax-deductible? In turn, the company can even borrow the funds it needs, which essentially allows it to deduct both principal payments and interest on the loan.
When a company is structured as an S corporation, the allocable share of income from the ESOP is exempt from federal income taxes. (Most states have a similar exemption). So, S corporations that are entirely owned by an ESOP can often avoid both federal and state income taxes altogether. It is essential to keep in mind that S corporation ESOPs also come with their own set of tax disadvantages, such as the prevention of owners from deferring gains on shares sold to the ESOP.
While there are a range of benefits, the costs of an ESOP can add up. These costs include the expense of annual appraisals, stock repurchase obligations, qualified plan administration, and loan payments. It’s important to weigh these costs with your advisor before choosing to embrace this particular strategy. Tax reform may also potentially affect ESOP and specific estate planning strategies, so it’s imperative that you consult your CRI tax advisor before making any critical decisions.