There are plenty of questions that can arise when considering an ESOP for your business. What is an ESOP? What are the benefits of an ESOP? Is an ESOP right for my business? Owners looking to transition out of the business, especially, should look closely and see if an ESOP is right for their company.
What is an ESOP?
Employee Stock Ownership Plans is an employee program that provides the employees an ownership interest in the company. Specifically, ESOPs are trusts that acquire/hold/sell the company’s stock for the benefit of participants in the ESOP, the employees. Typically, the company borrows money from lenders, investors, or selling shareholders, and then loans the ESOP trust funds for the purpose of acquiring shares. As the ESOP loan is paid down, shares are allocated to employee accounts annually, generally in proportion to the employee’s annual compensation. Employees then receive cash in exchange for their shares upon retirement, termination, disability, or death.
What are the Benefits of an ESOP?
There are many benefits to setting up an ESOP, ranging from company performance to tax incentives. They can greatly affect the selling shareholders, employees, and the actual company. Luckily, a lot of these benefits can impact the wallet in a good way through tax savings.
- If you are a shareholder of a C Corporation, for example, and you sell your ownership to the ESOP, you are able to “rollover” the proceeds from the sale into a tax free investment. This strategy defers the capital gains tax until the investment asset is liquidated.
- The company can make discretionary annual contributions to the ESOP which are 100% tax-deductible.
- Whenever the ESOP borrows money to buy your shares, the company can make tax-deductible contributions to the plan to repay the loan. Contributions to repay principal are deductible on up to 25% of the plan participants' payroll, however, interest is always deductible.
- ESOPs do not pay any federal income taxes.
- Stock ownership plans provide packages that act as additional benefits for employees in order to prevent hostility and keep a specific corporate culture that company managements want to maintain.
Is an ESOP Right for My Business?
Implementing an ESOP is a complete transformation of your company. You need to make sure your business is ready and able for the transformation. Your business needs to be large enough to take on the initial investment of setting up an ESOP, and also have the cash flow to maintain the plan. Ideally, you want your business to be growing, so the value of the ESOP grows with the company. Generally, an ESOP can cost anywhere from $50,000 to $250,000 to officially implement. A general guideline as to the size of the business is more than 25 employees and at least one to five million in annual revenues. One more important key to implementing a successful ESOP is management’s culture. A strong management must be in place, with plenty of management experience and a willingness to promote the incentives the ESOP will offer. This will start a new culture within the company that trickles down to employees and hopefully empower them in the process.
Currently, there are more than 7,000 ESOPs in place with more than 13.5 million participants. An ESOP is a powerful mechanism to transfer ownership to a company’s employees, and at the same time deliver remarkable tax benefits to the company and its existing owners.