Mention an ESOP and some people might think you are talking about Aesop's fables. Though the two sound the same, it's doubtful the ancient Greeks ever considered selling their businesses through an Employee Stock Ownership Plan. Once this can be explained as a mechanism for doing so, some owners will show a great deal of interest in an ESOP. Perhaps you will, too.

What is an ESOP?

ESOP is short for Employee Stock Ownership Plan. It is a mechanism to vest ownership in a company in its employees.

Why would you want an ESOP?

One of the best reasons to create an ESOP is to provide a market for a departing shareholder's interest in a company. Establishing an ESOP can also be an effective way to reward employees and offer incentives for desired performance. Additionally, ESOPs are a tax-effective way to borrow money for asset acquisition.

How does an ESOP work?

An ESOP is a qualified employee benefit plan under the Employee Retirement Income Security Act of 1974. Typically, a business establishes a trust to obtain company stock. The ESOP can be funded either by the donation of newly issued stock from the company or the cash to purchase existing shares. The ESOP can also purchase shares in the company by issuing debt and acquiring stock with the proceeds. The company would then make periodic contributions to service the debt. Regardless of the method of funding, company contributions are tax deductible, based on certain limitations.

Shares held by the trust are allocated to the individual employee accounts. With some exceptions, all full-time employees over the age of 21 participate in the plan. Allocations to employees are based on a formula established in the plan. Typically, the longer the time of service and the greater the employee's pay, the more shares are allocated to him or her. Ownership does not necessarily vest immediately, but an employee must be fully vested within three to six years.

Upon an employee's termination, he or she receives the stock in his or her account. The company must then repurchase that stock from the employee at its fair market value, as determined by an independent appraisal. However, if the company is a public company, the buyback price is based on publicly traded stock quotes.

Advantages of ESOPs

Using an ESOP can be a cost-effective way to buy out departing shareholders because ownership passes from them to the ESOP trust. The company makes tax deductible contributions to the ESOP to pay for the purchase.

In many cases, the ESOP borrows the funds to buy out a departing owner. In order to repay the loan plus the related interest, the company makes a tax-deductible contribution to the ESOP. This makes both principal and interest tax deductible. Compare this to a company's direct purchase of stock from a departing stockholder where the cost of the treasury stock is not deductible.

A final use of the ESOP is, of course, to offer additional benefits to employees.

Tax Effects

If a company chooses to fund the ESOP with stock, the stock contributions are tax deductible. In effect, the company can issue stock at no cash cost and reduce its taxable income. The resulting tax savings enhances the company's cash flow.

Cash contributions to the ESOP are also tax deductible. The cash need not be immediately used to acquire stock, but it can be retained to meet future repurchase obligations or to purchase stock in the future.

As previously mentioned, by virtue of using tax-deductible contributions to the ESOP to service debt, the after-tax cost of the ESOP is greatly reduced.

Finally, and most significantly for the departing owners, if the ESOP ownership interest in the company is 30 percent or greater, the shareholder can reinvest the sales proceeds in publicly traded securities and defer recognition of the gain until a future period.

If the ESOP is an owner in an S Corporation, its pro-rata share of income is not subject to income tax, although it must still receive distributions proportionate to its ownership interest.

Dividends are tax deductible. Dividends used to repay an ESOP loan, or those that are passed through to employees or reinvested in company stock by employees are tax deductible. The dividends must be reasonable in comparison to dividends paid by other companies.

Employees do not pay tax on contributions to ESOPs. Rather, they pay tax only when they receive a distribution from their accounts.

So, what's the catch?

If all of this sounds too good to be true, it really isn't. However, as with everything in the employee benefit arena, there are stringent rules governing the operation of ESOPs. In addition to typical reporting requirements applicable to other employee benefit plans, the requirement for appraisals of the stock can make the ESOP costly. ESOPs are not available to partnerships and most professional corporations. Additionally, while ESOPs are available to S Corporation shareholders, the gain on the sale of the shares cannot be deferred by reinvesting the funds in another qualifying security.

As with all things, whether an ESOP is a viable alternative for your business or not requires careful evaluation based on your company's circumstances. If you believe your company could benefit from one, give us a call and let's discuss your alternatives.

Have a great Independence Day.