Employee stock option plans (ESOPs) are qualified retirement plans akin to 401(k) plans except that ESOPs must invest primarily in their own company’s stock. From the looks of it, ESOPs could work for just about any privately held company that expects to grow, has a strong leadership team in place and proven business success. But ESOPs have some disadvantages that prevent them from being suitable for all.
When Do ESOPs Make Good Ownership Strategies?
ESOP companies have the potential to benefit the company itself, employees, and existing owners. Existing owners have the most to gain, but only if they are fully accepting of ESOP doctrines. ESOPs work well when existing owners:
Want a reliable exit strategy
ESOPs create a market for the shares of private companies that would not be easily salable otherwise. This gives owners a surefire path to exiting the business. Rather than finding a buyer when they are ready to leave, they can sell their shares to the ESOP and walk away with cash.
ESOPs let owners leave when they want to leave. They can choose to sell shares to the ESOP all in one go or slowly over five or ten years. This flexibility can help owners plan for retirement and prepare their finances for tax bills resulting from their stock sales – that is, if taxes apply.
Hope to save taxes
Many ESOP company owners can defer or eliminate their tax bills. Shareholders of C corporations, for example, can defer taxes resulting from their stock sales by making Section 1042 elections. If they (1) sell at least 30% of their stock to the plan, and (2) reinvest those proceeds into qualified replacement property (QRP), they can defer taxes on the sale of their corporate stock until they sell that QRP.. S corporations are not eligible for Section 1042 elections, but 100% owned S corporations will have no federal income tax to report since ESOPs are tax exempt trusts.
Additionally, ESOP contributions are tax deductible. This means that when ESOPs purchase owners’ shares, they are doing so with pre-tax dollars. In effect, this lets companies buy their shareholders out a lower cost.
And lastly, when ESOPs are leveraged, payments made to satisfy debt obligations (both interest and principal) are typically deductible.
Plan to stay for the long haul
ESOPs can be great incentives for senior management to stick around. By reducing turnover, especially in those high-powered positions, organizations can see their initiatives through and build even more value in the business.
Hire employees who are empowered to improve the business
Workers with ambition will be the ones who find value in ESOPs. Selecting employees who are good workers alone will not be enough; those workers must have a desire to one day run the business. Owners of ESOPs must be willing to let go of the reigns and look forward to the day when those ambitious employees take over their company.
How Can You Know for Sure?
The best way to see if an ESOP will work for your business is to conduct a feasibility study. Feasibility studies can be performed internally, but an external CPA will know what questions to ask and what factors to consider. Feasibility studies first outline management’s goals to ensure those goals align with ESOPs’ potential benefits. The study will then explore financing options for opening the plan – can your cash flow or debt ratios support the plan? And most importantly, your CPA will run scenarios to see if your individual owners will save taxes with an ESOP.
If you are considering an ESOP contact us today to further discuss your company’s options.