ESOPs Offer Significant Benefits For Business Owners
Let’s say you are an owner of a successful privately-held company and you would like to cash out the substantial value reflected in your business. In addition, you would like to find an appropriate buyer for your company, a person that will carry on the business legacy you built and will continue to treat your employees in a manner similar to the way you treat them. A buyer in the form of an “employee stock ownership plan” (“ESOP”) may be the answer.
What Is An ESOP?
An ESOP is a tax-qualified retirement plan that is designed to be primarily invested in the company’s stock. Thus, since ESOPs must hold “company stock,” ESOPs must be maintained by corporations for federal income tax purposes (e.g., regular C corporations or Subchapter S corporations). LLCs and partnerships are not eligible to maintain ESOPs.
Favorable Tax and ERISA Benefits
As a tax-qualified retirement, company contributions to the ESOP, within IRS-prescribed limits, are tax deductible by the company. Moreover, ESOPs are uniquely allowed to borrow money from the company or other third parties to enable the ESOP to fund the purchase of company stock. Thus, an ESOP’s purchase of stock from a company owner can effectively be financed with fully tax deductible dollars, even the amounts applied by the ESOP to repay the principal on the loan used by the ESOP to purchase the owner’s shares.
Special ESOP Gain Deferral Rules
Special provisions in the Internal Revenue Code permit an owner (or owners) selling stock in a privately-held domestic C corporation to an ESOP to defer the recognition of the gain on the sale if certain tax law requirements are met. Such requirements include (i) the ESOP must own at least 30% of the company’s stock immediately after the sale, and (ii) the selling shareholder timely reinvests the ESOP sale proceeds in stocks and/or bonds of U.S. operating corporations. Thus, a company owner can liquidate his or her ownership interest in the company and pay no federal income tax upon a sale of stock to an ESOP, and at the same time favorably diversify his or her wealth among a portfolio of U.S. corporate stocks and bonds. In addition, the sale of stock to the ESOP effectively sells such portion of the company to the company’s employees through their participation in the ESOP, thus allowing the employees to obtain a vested equity stake in the future appreciation in the value of their company. Such “skin in the game” for employees can provide a powerful basis for increasing employee commitment and productivity for the betterment of the company and its owners.
As the above discussion indicates, the use of an ESOP to facilitate the sale of a privately-held company owner’s stock may prove to be a “win-win” result for the company owner, the company, and its employees.