An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that can create value for a company’s retiring shareholders as well as its employees. Really good privately-held businesses typically make the best ESOP candidates. By good, we mean those with a long history of increasing earnings, revenue, and cash flow, and with a strong management team that can run the company in the absence of its prior shareholders.
Having an employee base with a diverse group of ages is also helpful. If all of your key employees will be retiring within the same timeframe, it could put a strain on your management continuity and your cash flow (although there are some provisions you can put in the plan to protect the company).
Exiting shareholders benefit by selling their stock into the ESOP and deferring the taxable income, subject to certain IRS restrictions. This could be a significant tax benefit to an older shareholder who never triggers the gain recognition. In this scenario, the shareholder’s estate could get stepped up basis to fair value and the capital gains tax would be eliminated.
Another ESOP advantage for retiring or exiting owners is that a majority owner does not necessarily have to relinquish control of the company.
The company and its current employees can also benefit from an ESOP:
- Contributions to the ESOP are tax deductible, just like pension contributions.
- The ESOP may be able to get financing from the bank to fund all or a portion of the stock purchase from the prior shareholder(s).
- If the company is an S Corporation, a portion of the company’s taxable income may be tax free (i.e. the income attributable to the ESOP’s ownership).
- Most employees will become owners of the company’s stock once they become participants in the ESOP.
- National studies have confirmed that ESOP owned companies are typically more profitable.
Some potential disadvantages of an ESOP:
- If 100 percent of the stock is owned by the ESOP, key management may not feel they are getting all the appreciation of the value that they deserve.
- If a majority shareholder only sells a portion of their stock to the ESOP and the business cannot afford to repurchase additional shares, the majority shareholder’s options to create a liquidity event for the remainder of their shares could be limited.
- Certain family members and remaining stockholders may not be eligible to participate in the ESOP.
- If the company does not perform well, employees could see their stock value decrease.
As with any business decision, owners who are thinking about their exit options need to entertain all the alternatives, define their objectives, and then decide the best way to “cash in” their stock.