Inside an ESOP
FAQs regarding employee stock ownership plans
When it comes to exiting a business and monetizing the wealth trapped in the company, an owner can consider five general methods of exiting: a sale to an outside party such as a competitor or strategic partner; a sale to a private equity group; a sale to a manager or group of managers in a management buyout structure; a gift of shares to children; or an employee stock ownership plan, or ESOP. But what exactly is an ESOP and how does it work? This article provides some structure to the ESOP strategy, and addresses pros, cons and myths about the ESOP.
ESOP: A Tax-efficient Business Exit
When making the decision to exit a business, an owner must consider the tax effect that the transition will have. Most forms of business exit, including management buyouts or sales to outside organizations, require the business to be acquired using after-tax dollars. In other words, this means that a business must earn profits, pay taxes on those profits, and then use the net proceeds to purchase the assets or stock.
Some forms of business exit incur additional tax penalties for the owner. When the proceeds of a sale are exchanged for the assets or stock, the seller may be in a position to pay additional taxes in the form of capital gains. The combination of the taxes paid on the transactions can sometimes result in a tax yield or combined effective tax consequence of 50 percent or more between the income and capital gains taxes.
An employee stock ownership plan, or ESOP, on the other hand, limits the tax penalty for both the acquiring parties and the seller. Unlike most forms of business exits, an ESOP does not require the use of pre-tax dollars for the business acquisition. Additionally, the ESOP eliminates much of the tax obligation for the seller. Provided the ESOP is properly structured, the seller of a business can effectively eliminate the entire tax obligation on the transaction. As a result, the ESOP is an alternative that should be on every business owner’s radar when considering the sale of their closely held business.
What is an ESOP?
In very simplistic terms, the ESOP is nothing more than a qualified retirement plan. In a traditional profit-sharing retirement plan, the closely held business makes tax deductible contributions to the plan for the benefit of its employees. When the funds get into the plan, the trustee typically invests those funds in marketable securities such as mutual funds. Those fund values are then allocated to the individual participants’ accounts subject to certain requirements such as vesting, years of service, salary, etc.
The ESOP works in much the same manner, however, instead of investing funds in marketable securities, the trustee will use the funds to acquire private company stock, or in this case, the operating company stock. The stock acquired is then allocated in the same manner that profit-sharing allocations are made.
How does the plan obtain the shares of stock?
An ESOP tax structure is that of a non-tax paying trust. Once the trust is established and obtains approval from the Internal Revenue Service, the shareholder(s) will sell their shares to the trust at a value determined by a business appraiser. In exchange for the shares, the seller will typically get two forms on consideration in return: cash or promissory note. If cash is required by the seller at closing, the trust will have to get outside bank financing using the strength of the operating company.
Alternatively, the seller can become the bank and, thus, finance the sale. Repayments of the loan are made through deductible retirement plan contributions from the company to the trust. The funds are then used by the trust to repay the loan obligations.
What is the sales price for my shares?
The IRS has established strict guidelines for valuing a closely held company’s stock. The guidance that business appraisers use is IRS Revenue Ruling 59-60. This revenue ruling considers the many steps an appraiser must consider and the information an appraiser must evaluate in order to make a conclusion of value.
Under Revenue Ruling 59-60, an appraiser must consider the marketability of the stock that is being sold. Closely held businesses typically have limited marketability, and thus would warrant a marketability discount.
If the block of stock being sold is not a controlling interest, then a secondary discount would normally be applied. This is called a minority interest discount, or discount for lack of control. The concern here is that when a business owner sells his or her shares, they could yield a lower sales price than anticipated. However, with the tax benefits the owner may net as much or more than a traditional sale, regardless of the discounts.
Are employee owners required to see company records?
With regards to sharing the books and records with ESOP employees, the business owner should consider the original intent for establishing the ESOP. It was meant as a benefit for the employees. While every detail is not required to be shared with employees, it would be a good idea to do so. It can be a benefit to educate the workforce on running a profitable and efficient business, and on how company performance would affect the business valuation and ultimately their retirement results.
How will the trust pay out the benefits when the participants begin to retire?
Simple answer, the company pays for everything. The repurchase obligation can be a significant issue with ESOP’s. The company can continue to issue dividends to the trust, which allows the trust to acquire cash and pay out benefits. Since the trust is a non-taxpaying entity, there would be no tax consequences to the trust. However, should a company have a workforce with similar demographics, and they begin to retire within a short period of time, this can create a significant cash flow burden to the company.
What are the administrative costs of an ESOP?
ESOP expenses are typically greater than that of a traditional qualified retirement plan. The standard costs will include the costs of an administrator that is used to keep track of participant statements, prepare annual reports, compute repurchase obligations and prepare the annual form 5500 tax return.
There will also be an annual appraisal fee to determine the value of the shares at the end of the year. Additional costs may include legal fees for the operating company and the trustee.
Overall, an ESOP has some great benefits to the seller of the stock as well as the employees who are participating in the plan. If an owner is considering an ESOP, it is important to understand the tax savings benefits that an ESOP can offer in addition to the resources of time and money that will be required to establish and maintain it.