Employee Stock Ownership Plan

Do you own a closely held company? Are you approaching retirement age? If so, you may be struggling to balance conflicting goals for your business. An employee stock ownership plan (ESOP) may help. Business owners often need to tap at least some of the value of their business to fund their retirement. At the same time, they may wish to preserve their company for their children, employees and community. Further complicating matters is that there can be tax advantages to transferring ownership to the next generation as early as possible. Yet owners aren’t always prepared to walk away from their company when it makes the best sense from a tax perspective.

Possible solution

Enter the ESOP. This tool can provide a tax-efficient exit strategy that allows you to remain in control until you’re fully ready to retire. A note of caution: ESOPs are available only to corporations. So if your business is organized as a sole proprietorship, partnership, or limited liability company (LLC), you’ll have to convert it into corporate form (a potentially complicated proposition) to take advantage of this strategy.

An ESOP is a type of qualified retirement plan. But instead of investing in publicly traded stocks, bonds, and mutual funds, an ESOP is designed to invest primarily in your company’s stock. Like other qualified plans, it’s subject to rules and restrictions, including contribution limits and coverage requirements. Unlike other plans, however, ESOPs must obtain annual independent appraisals of their stock.

When employees become eligible for benefits, they receive the vested portion of their ESOP account balance in the form of stock or cash. If your company is closely held, employees who receive stock must be given a “put option” — the right to sell the stock back to the company during specified time windows at fair market value.

Count the benefits

The advantages for owners are significant. By selling some of your company stock to an ESOP, you achieve greater liquidity, diversification and financial security. What’s more, if your company is a C corporation and the ESOP acquires at least 30% of its stock, you can defer any taxable capital gains on the sale by reinvesting the proceeds in certain qualified securities.

Giving up ownership, however, doesn’t mean giving up control — at least not right away. You can continue to serve as your company’s CEO and, as a trustee of the ESOP trust, vote on most corporate decisions.

ESOPs also make sense from an estate planning perspective. Selling shares to your company’s plan provides you with liquid assets to distribute to children or other family members who aren’t involved in the business. At the same time, you can hold on to enough stock to transfer control of the business to those who are involved.

Business boon

By tying the value of the ESOP to your company’s stock, you give employees a powerful incentive to work hard for the business’s future. Company contributions to the ESOP that are used to acquire your stock are tax-deductible, and the company can even borrow the funds it needs — essentially allowing it to deduct both interest and principal payments on the loan.

If your company is structured as an S corporation, the ESOP’s allocable share of its income is exempt from federal income taxes. (A similar exemption is available in most states.) This means that an S corporation owned 100% by an ESOP can avoid federal income taxes — and often state income taxes — altogether. However, keep in mind that S corporation ESOPs present certain tax disadvantages as well, such as preventing owners from deferring gains on shares sold to the ESOP.

Consider the costs

Despite the benefits, ESOP costs can add up — including the expense of annual appraisals, stock repurchase obligations, loan payments and qualified plan administration. In addition, tax reform could potentially affect ESOP and estate planning strategies. Weigh such costs with us before adopting this strategy. You may view a copy of this and other FBD memos on
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