If you are an owner looking for a long-term exit strategy, or if you have employees who think like business owners, or if you are a private company with 30 or more employees, you might want to consider forming an ESOP.  This article explains ESOPs and their tax benefits.

What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is a company-funded retirement plan that holds company stock in accounts for the employee participants.  An ESOP is a tax-qualified pension plan where the employees of a firm are the beneficial owners of its stock. 

To set up an ESOP, a company creates an Employee Stock Ownership Trust (ESOT) (also referred to as an ESOP Trust) and funds it with company contributions, not by the employee-participants themselves.  Employer contributions to the ESOP generally are tax-deductible under §404 up to a limit of 25% of covered payroll. 

Employees do not directly buy or hold shares through the ESOP.  Instead, the Plan Trustee buys, holds, and sells the shares in the Trust’s name for the benefit of the employees.  Normally, all full-time employees aged 21 and older participate in the ESOP; however, there can be restrictions similar to other pension plans.

Determining ESOP Feasibility

The best ESOP candidates have:
• Eligible payroll of approximately $1 million or more
• A business with a current minimum market value of at least $5 million
• Capable successor managers
• Good revenue and earnings history
• The ability to secure financing
• C or S corporation tax status

A business owner with any of the following goals should consider the advantages of an ESOP:

• Improve business performance through equity incentives
• Share equity in the company with employees to attract, retain and reward a productive workforce
• Enable some or all current shareholders to sell their stock on a tax-free basis
• Enable shareholders to diversify their holdings in the company on a tax-free basis and still maintain control of the company
• Buy out inactive minority shareholders on a tax-deductible basis for the corporation and a tax-free basis for the selling shareholders

The Cost of an ESOP

ESOPs are not cheap and the cost of both creating and maintaining an ESOP should be strongly considered.  The evaluation and implementation of an ESOP is complex and requires multiple levels of tax, legal, actuarial, financial and administrative expertise.
 
 
ESOPs typically cost at least $50,000 to set up, depending on the complexity and the size of the transaction.  For larger companies, these fees can quickly add up to $500,000 or more.  An ESOP is more expensive than other benefit plans but usually much cheaper than other ways to sell a business.  Some of the fees involved in an ESOP include a financial feasibility study, legal fees for both the employees and the employer, investment banking fees to help find financing, bank charges, trustee charges and formal valuations of the company initially and on an annual basis.  In addition, there are administration fees which typically range from $3,000 to $10,000 a year.

Tax Benefits to the Selling Shareholder

One of the major benefits of an ESOP for closely held companies is IRC §1042, which allows the seller to an ESOP to qualify for an indefinite deferral of taxation of the gain made on the sale.  To qualify for §1042 treatment, the following must apply:

1. The seller must have held the stock for at least three years before the sale
2. The stock must not have been acquired through options or other employee benefit plans
3. After the sale, the ESOP must own at least 30% of the value of the shares in the company and must continue to hold this amount for three years unless the company is sold.  Shares repurchased by the company from departing employees do not count.
4. The company must be a regular C corporation
5. The employer company must file a consent to the tax-free rollover transaction

If these rules are followed, the seller(s) can take the proceeds from the sale and reinvest them in “qualified replacement securities” within 12 months after the sale or three months before and defer any capital gains tax until these investments are sold.

Qualifying replacement securities are essentially defined as stocks, bonds, warrants, or debentures of domestic corporations receiving not more than 25% of their income from passive investments.  Mutual funds and real estate trusts do not qualify.  Another advantage is that if the replacement securities are held until death, they are subject to a step-up in basis so capital gains taxes would never be paid. Estate taxes would be considered on the value of the replacement securities that might be avoided through effective planning.
 
The ESOP is required to hold the employer securities which it has purchased for at least three years after the acquisition date.  If the ESOP disposes of part or all of these securities (other than by means of a normal distribution to a terminated or retired participant), then the company will be liable for a 10% penalty tax which is based on the value of the employer securities sold by the ESOP.

Strategies for Existing S Corporations

If taxpayers want to take advantage of tax-free rollover treatment under §1042, they should consider terminating their S election prior to making the sale of the stock to the ESOP.

However, an S corporation can do ESOP planning.  The great majority of existing S corporations that adopt ESOPs elect to continue their S status so that the corporation can take advantage of the ESOP “tax shield” that applies to the portion of the corporation’s taxable income that is attributable to stock held by the ESOP.  In the case of an S corporation that is 100% owned by its ESOP, the company’s earnings will be entirely tax exempt for federal tax purposes.  However, stock acquired by an ESOP adopted by an S corporation will not be eligible for tax-free rollover treatment under §1042.

More Advantages of ESOPs

National studies reveal that on average, ESOP companies tend to be at least 8% to 11% more profitable than their non-ESOP counterparts.  Highly motivated employees owning a part of the company generate increased profits. The employees are encouraged to take a more active interest in company performance because they share in the equity growth created through productivity increases.  In addition, a company can increase profits by paying significantly less corporate income tax than they would have without the ESOP through deductible contributions to the Plan.  This reduction in corporate income tax will help increase the cash flow and net worth of the company.
Disadvantages of ESOPs

While there are significant advantages to implementing an ESOP, there are also a few disadvantages that must be considered.  If the value of the company’s shares falls, then employees share the loss and morale may suffer.  In addition, if the contribution is in the form of newly issued stock, then the ESOP dilutes the current stockholders’ ownership.  The first step in determining if the advantages of an ESOP outweigh the disadvantages is to complete a feasibility study to help determine if an ESOP is a good choice for the company.