Well … I guess that was Aesop, but still – is it just a “fable” that ESOPs should be considered by a business owner considering a transition or sale of his/her company? The short answer is “no – it is not a fable – it is a remarkable tool where it fits.”
The “Why?” Behind the What
Employee Stock Ownership Plans (“ESOPs”) are the most common form of employee ownership of companies in the United States. ESOPs are governed by federal pension law, specifically the Employee Retirement Income Security Act, commonly abbreviated “ERISA.” (Contrary to popular belief, that is not short for “Every Ridiculous Idea Since Adam.”) An ESOP is an ERISA-qualified retirement plan that primarily invests in the stock of the sponsoring company.
The National Center for Employee Ownership estimates that in 2015, 7,000 companies have ESOPs, covering an estimated 13.5 million employees. Since the beginning of this century there has been a decline in the number of ESOP plans but an increase in the number of participants. The great majority of ESOPs (more than 90%) are located in privately held companies.
Why Should I Consider Using an ESOP?
There are three main reasons to use an ESOP:
- To buy the shares of a departing owner—about two-thirds of all ESOPs are established to purchase a departing owner’s shares of a closely held company – tax deferred, I might add;
- To borrow money at a lower after-tax cost—the tax advantages of ESOPs make them an attractive option for corporate financing. ESOPs are the only retirement plans allowed by law to borrow money, which can be very attractive to company owners as instruments of corporate finance and succession. The ESOP can borrow cash, which it then uses to buy company stock or to buy stock for its employees. Banks generally get benefits for making ESOP loans, which means they can offer loans/terms at more favorable rates, too;
- To create an additional benefit to employees—the company sets up a trust fund for employees and contributes cash to buy company stock or contributes shares directly to the plan. On average, employers contribute 6%-10% of the employee’s pay into an ESOP each year.
Are There Any Tax Benefits of ESOPs?
As a matter of fact, there are seven main tax benefits of ESOPs:
- Stock contributions are tax-deductible—a company can obtain a current cash flow advantage by issuing new shares to the ESOP;
- Cash contributions are tax-deductible—a company receives a tax deduction on cash contributions, regardless of whether the contributions are used to buy shares from employees or used as a cash reserve in the ESOP for future use;
- Contributions used to repay an ESOP loan are tax-deductible—the ESOP can borrow money to buy existing shares or new shares. The repayment of the principal and the interest on the ESOP loan are tax-deductible;
- Sellers in a C corporation can defer the payment of taxes—once the ESOP owns at least 30% of the shares of a C corporation, the seller can reinvest the proceeds of the sale in other securities and defer any taxes on the gain;
- An S corporation does not pay federal income tax on any profit attributable to the ESOP’s ownership of stock—the favorable federal tax benefits may explain why most private companies who operate ESOPs are S corporations. While most states mirror the federal government and do not tax profits attributable to an ESOP’s ownership of stock, the State of California places a 1.5% tax on the net income of an S corporation;
- Dividends are tax-deductible—reasonable dividends used to repay an ESOP loan, passed through to employees, or reinvested by employees in company stock are all tax-deductible;
- Employees do not pay any taxes while the employer is making contributions to the ESOP—the employee is not taxed on the ESOP contributions until they receive a distribution from the plan when they leave the company. When an employee leaves, they receive their vested ESOP shares, which the company or the ESOP buys back at an appraised fair market value.
Sounds Too Good – What Are the Disadvantages To An ESOP?
While there are many advantages to an ESOP, there are three main drawbacks to consider.
- ESOPs are expensive to set up and maintain. The cost to set up an ESOP for most closely held companies ranges from $60,000 to $100,000, with a minority in the $100,000 to $200,000 range. And the yearly maintenance fee for an ESOP is also more expensive than other qualified retirement savings plans because closely held companies must obtain an independent appraisal of all of the assets held by an ESOP, not just company stock, each year.
- ESOPs concentrate employees’ retirement savings in the stock of their employer. Concentrating the ESOP investment solely in the employee’s company puts the employee at risk of having “too many eggs in one basket.” The employee should diversify investments across many companies, industries and geographic locations as well as different investment categories, such as stocks (growth and value stocks), bonds, real estate, cash, etc.
- One way to alleviate ESOP’s narrow concentration is for the company to offer at least one additional qualified retirement plan, such as a 401(k) plan, where the employee can invest in a broader diversification of investment classes.
- Another way to alleviate the ESOP’s narrow concentration is that an employee has the right to diversify a portion of their ESOP contributions when they have participated in the plan for at least 10 years and are at least 55 years old. An employee with 10 years of plan participation can diversify up to 25% of the shares in their ESOP account at age 55 and each year thereafter until they reach 60, when the employee can diversify up to 50% of the shares in their ESOP account.
- Dilution in stock value and stock availability. Any time the company issues new shares of stock, the value of the stock owned by the existing employees is diluted. And newer employees can be left without much opportunity to participate if most of the shares have already been provided to longstanding employees.
So … ESOP’s are a great tool where they fit, but it is not something you want to “try at home.” This has a number of factors that need to be carefully evaluated before taking any actions or making any changes. If you would like further information on ESOPs or just want to “kick it around,” feel free to contact us at Wealth Legacy Group, Inc. I can be personally reached at rj@wealthlegacygroup.com or by office phone at (858) 569-0633. There are other ways to sell your business and not pay tax, but every situation is different. More than most other tools, an ESOP requires a diversified team to help you evaluate, implement and monitor. Still … the “good news” of an ESOP is that the Internal Revenue Service will actually allow you to sell your company and not have to pay a tax … and not go to jail!
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Written by R. J. Kelly – August 2015