Most business owners have significant wealth tied up in their companies. If you are in the same boat, how can you convert some of that wealth into cash to help pay for your retirement? Many C corporation owners have found that an Employee Stock Ownership Plan (ESOP) — a qualified retirement plan that is similar to a profit sharing plan — can help pave the way to a comfortable future.
The main difference between an ESOP and other types of retirement plans is that, instead of investing in a variety of stocks, bonds, and mutual funds, an ESOP invests primarily in the employer’s own stock. The employer makes tax-deductible contributions to the ESOP, which the ESOP uses to acquire stock from the company or its owners. Essentially, by establishing an ESOP, you are creating a buyer for your shares.
At the same time, you provide a powerful incentive for employees, who now have an opportunity to share in the company’s growth on a tax-deferred basis. When employees retire or otherwise qualify for distributions from the plan, they can receive benefits in the form of stock or cash.
Like other qualified plans, ESOPs are strictly regulated. They must cover all full-time employees who meet certain age and service requirements, and they are subject to annual contribution limits (generally 25 percent of covered compensation), among other conditions.
ESOPs are also subject to rules that do not apply to other types of plans. For example, an ESOP must obtain an independent appraisal of the company’s stock when the plan is established and at least annually thereafter.
Also, participants who receive distributions in stock must be given the right to sell their shares back to the company for fair market value. This requirement creates a substantial repurchase liability for which the company must be prepared.
An ESOP provides several tax benefits. If the ESOP acquires at least 30 percent of your C corporation, you can defer the gain on the sale of your shares indefinitely by reinvesting the proceeds in qualified replacement property within one year after the sale — an advantage over an outright sale. Qualified replacement property includes most securities issued by domestic operating companies.
ESOPs are unique among qualified retirement plans because they permit a company to finance the buyout with borrowed funds. A “leveraged” ESOP essentially permits your company to deduct the interest and the principal on loans used to make ESOP contributions — a tax benefit that can do wonders for cash flow. Your company can also deduct certain dividends paid on ESOP shares. Interest and dividend payments do not count against contribution limits.
Another advantage of ESOPs over sales or other exit strategies is that they allow you to cash out without giving up control over the business. Even if you transfer a controlling interest to an ESOP, most day-to-day decisions will be made by the ESOP’s trustees, who can be company officers.
However, ESOP participants may have the right to vote their shares on certain major decisions, such as a merger, dissolution, or sale of substantially all of your company’s assets.
ESOPs can work for S corporations, too, but there are some significant differences in how the ESOP rules apply. The deferral of any gain on the sale of your shares in the S corporation is not allowed. However, if the owner does not need or want the tax deferral treatment available to C corporation owners, the S corporation ESOP can provide a powerful tax incentive. As the ESOP is a tax exempt entity and the S corporation is a flow-through entity, its share of the S corporation’s taxable income is not subject to federal income taxes and is not subject to most states’ income taxes. This ability to avoid taxation allows the corporation to save significant cash.
If you are thinking about retirement or diversifying your assets, an ESOP might be the vehicle to get you there. But be sure to work closely with your advisors, because ESOPs are extremely technical.
Contact us at 215.441.4600 if you have questions or would like to discuss how this topic may impact your business.
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