This article originally appeared in the November 2015 issue of Smart Business Philadelphia.
The decision to sell your business to an Employee Stock Ownership Plan (ESOP) requires both time and attention to detail, says Brian J. Sharkey, director of Audit & Accounting at Kreischer Miller. “If it aligns with your long-term goals for the business and what you want your legacy with the business to be, it can be a very good option,” Sharkey says. “As you navigate the decision process on an ESOP, it is essential to align with the proper advisers to ensure those important goals are achieved.”
An ESOP is a qualified retirement plan that is similar to a profit sharing plan except that instead of investing in a variety of stocks, bonds and mutual funds, it invests primarily in the company’s own stock. The employer makes tax-deductible contributions to the ESOP, which the entity uses to acquire stock from the company or its owners. Essentially, by establishing this plan, you are creating a buyer for your shares.
Smart Business spoke with Sharkey about what to think about when considering an ESOP for your business.
What are some of the key advantages to forming an ESOP?
The formation of an ESOP can provide benefits to the company, the selling shareholder and the employees. If you’re the owner of a C corporation and you sell your shares to an ESOP, you can defer taxation on the proceeds as long as you reinvest them in certain U.S. securities. You can then defer paying the taxes until years later, when you sell the underlying securities to fund your retirement. And in certain situations, you can avoid paying taxes altogether.
The company will often need to borrow money to pay for the initial financing to purchase the shares from the selling shareholder. The good news is that companies are able to deduct the principle and interest on ESOP loans, which essentially allows the selling shareholder’s shares to be purchased with pre-tax dollars.
In addition, ESOPs themselves are not subject to federal income tax. So if your company is an S corporation, earnings passed through to the ESOP are not taxed. For example, if a company is 40 percent ESOP owned, 40 percent of the profits of an ESOP are not subject to federal tax. Companies that are 100 percent ESOP owned essentially pay no taxes. This provides ESOP-owned companies with a substantial competitive benefit because they can reinvest more earnings back into the company for capital needs or new product development. As for employees in an ESOP plan, they essentially receive indirect ownership in the company. The ESOP’s shares are owned by a trust and the employees become the beneficiaries. Providing employees with this benefit empowers them with an ownership mentality, and they will have a direct impact on increasing the value of the company.
How do you know whether an ESOP is the right plan for you?
An ESOP is just one of many options to transfer ownership, but it may not be the best. When considering an ESOP, you should look at your employee base, your profitability and your management team.
An ESOP provides you the option to sell all or a portion of the equity of your company to current employees who can continue the legacy of the business you’ve built – as long as you have employees who believe in it and want to do their part to keep it going after you’ve moved on.
Initial ESOP transactions will typically leverage the company, so it’s important that the company has sufficient cash flows to ensure those debt obligations will be met without hampering the long-term sustainability and growth potential of the business.
Finally, the management team will play a key role in running the company and maintaining the ESOP. You need a strong team in place to keep the company on the path of success you have created, and ensure that the organization’s culture remains positive.
When considering an ESOP as a transfer option, it’s critical to speak with the right advisers, such as an ESOP council, valuation experts, CPAs or trustees in order to weigh the pros and cons.
If you decide an ESOP is right for you, these same experts will help lead you through the formation process and keep your company on track going forward.
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