You’ve worked hard to build your
business, and now it’s time to think
about the future. Don’t let yourself get backed into a corner and have to sell
your business in a pinch. Why not consider selling it to your employees by setting
up an Employee Stock Ownership Plan
(ESOP)?
“Recent surveys indicate that some
60 percent of business owners lack a
succession plan,” says Carl J. Grassi,
president of McDonald Hopkins LLC.
“That’s worrisome because it’s important
to devote time and attention to building
your graceful exit.”
An ESOP is a qualified retirement plan
that allows you to sell your business to
your employees. It is designed to invest
primarily in the employer’s stock. ESOPs
are often used as vehicles to obtain
financing for the buyout of shares from
existing shareholders on a tax-advantaged basis.
Smart Business asked Grassi why business owners should consider an ESOP.
How do you determine if an ESOP is the right
fit for your business?
Ideally, an ESOP candidate is a corporation that has sufficient debt capacity; a
history of dependable, positive cash flow,
usually in a business that is not overly
cyclical; a strong management team; and
culture that promotes employee ownership. Also, it is important that the company have relatively low employee turnover
and sufficient annual payroll to take
advantage of the tax benefits associated
with an ESOP.
How does the process begin?
The business should consider an ESOP
feasibility study. The results of that study
will help the company decide whether to
proceed.
What are the tax incentives of an ESOP?
If, after the transaction, an ESOP owns
at least 30 percent of the outstanding
stock of the corporation, and proceeds
received by selling shareholders are rolled over into ‘qualified replacement property,’
the federal income tax realized from the
sale by a selling shareholder can generally
be deferred — this tax benefit does not
apply to an S corporation. The corporation will get a tax deduction for the interest paid to the lender and for an amount
equal to the principal repayments, generally not in excess of 25 percent of the eligible compensation of ESOP participants.
In an S corporation, whatever percentage
an ESOP owns, that is generally the percentage of the company’s taxable income
not subject to federal income tax.
How can a selling shareholder properly take
advantage of the income tax deferral?
To take advantage of the income tax
deferral, the proceeds received from the
ESOP must be reinvested, generally within 12 months of the sale, in qualified
replacement property, which I briefly
mentioned. Qualified replacement property includes stock or securities generally
issued by a domestic operating corporation. Reinvestment in shares of a mutual
fund or government securities does not
qualify as replacement property. Interest
or dividend income on replacement securities will still be taxed when received.
The gain previously deferred generally
will be recognized when the replacement
property is sold. Some shareholders may
not be eligible for this income tax deferral
treatment.
What are the benefits to other shareholders?
An ESOP may alleviate or limit the need
for insurance on the selling shareholder’s
life, establish the vehicle for future sales
of additional stock of the corporation, and
relieve remaining shareholders and the
corporation from the requirement of buying out selling shareholders’ shares upon
their death. Depending on the percentage
of the ESOP’s ownership of the corporation, the remaining shareholders may still
control the business.
What are the benefits to the corporation and
employees?
The ESOP provides a tax-advantaged
financing vehicle to buy out the stock of a
selling shareholder. The effect of an ESOP
transaction is that the interest and principal payments by the corporation on the
bank loan to fund its loan to the ESOP are
usually fully tax deductible. Accordingly,
the corporation is able to fund the buyout
of a selling shareholder with pretax dollars as opposed to after-tax dollars. For
employees, an ESOP can provide a significant stock-based, incentive-oriented retirement plan benefit. Employees will
share in the equity growth of the business.
What about potential drawbacks?
The shares sold to the ESOP must generally be held by the ESOP for three years
to avoid an excise tax. ESOPs of S corporations that have relatively few participants are restricted in allocating stock or
synthetic equity to certain persons.
ESOPs may be too expensive for small
companies. Setting up an ESOP is complex, and you have to take a close look at
debt financing and all the various requirements related to the tax treatment.
CARL J. GRASSI is the president of McDonald Hopkins LLC. Reach him at (216) 348-5400 or [email protected].