EMPLOYEE STOCK OWNERSHIP Plans (ESOPs) are a type of qualified retirement plan that invest primarily in employer securities. While other types of qualified retirement plans can provide for ownership in the employer, ESOPs are distinct because they are tax-advantaged financing tools for a corporation as well as an employee benefit program. 

ESOP advantages

§         One of the most popular tax advantages of an ESOP, at least historically, is that a shareholder may be able to sell his or her stock to the ESOP without current taxation of the gain on the sale. In order to qualify for this deferral of taxation, the shareholder must reinvest the sales proceeds in qualifying replacement property (basically other domestic stock or securities but not government obligations or mutual funds). If the selling shareholder holds the qualifying replacement property until death, the gain on the sale can be permanently avoided. This is only available if the company is a C corporation. 

Note: there are many additional requirements that must be satisfied related to this tax -deferred sale. For example, the ESOP must own 30% of the company after the sale and family members of the seller and other significant shareholders may not be able to participate in the ESOP. 

§         Typically, an ESOP is leveraged. This means that it has to borrow the funds needed to buy the stock. Because the source of the repayments on the loan comes from employer retirement plan contributions, both the principal and interest payments are tax deductible (normally only the interest payments would be tax deductible.)  

§         If the sponsor of the ESOP is an S corporation, another significant tax advantage is that there is no federal income tax on the portion of the income associated with the ESOP ownership interest.  Unlike a C corporation, an S corporation generally does not pay any corporate level income tax. Rather, the taxes are paid by the shareholders. If an ESOP owns 30% of the company, for instance, 30% of the earnings would go untaxed.

§         ESOPs can be used to motivate employees. One of the underlying objectives of many ESOPs is to improve employee productivity by giving the employees a financial stake in the performance of the company. There have been numerous studies performed illustrating, that in the right circumstances, the ESOP does indeed improve the financial performance of the company.  

Using an ESOP as a succession planning tool

Ms. Founder started her company in 1960. It has grown and is currently valued at $10,000,000. Ms. Founder is ready to retire and has no family members to take over the business and she does not want to sell to an outsider because she wants to business to remain intact as is. Her basis in the C corporation stock is $10,000. She sells 100% to the ESOP. The company thereafter makes an S election. Of course, not every ESOP will fit this mold but may benefit from one or more of the following tax advantages: 

§         Ms. Founder does not have to pay the capital gains tax of nearly $1,500,000 that would normally be due on a sale of 100% of her stock.

§         The ESOP is able to buy her stock with tax deductible financing.

§         Once the company makes the S corporation election, it essentially becomes a tax exempt entity and the dollars that would have been paid to the government can now be used to pay down the ESOP debt or finance the future growth of the company.  

There are many requirements that must be satisfied by an ESOP. It is crucial for a company considering an ESOP to work with experienced advisors who can help identify the potential obstacles to a successful ESOP through a feasibility study. 

For more information regarding employee stock ownership plans please visit www.rightfitretirementpartner.com. 

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