ESOP's May Help in Business Owners Succession Planning - Rodgers & Associates
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ESOP’s May Help in Business Owners Succession Planning

ESOP's May Help in Business Owners Succession Planning

One of the biggest challenges business owners face when planning their retirement is how to sell their company. A typical business owner has a large percentage of their net worth tied up in their company. Planning ahead is the key to making the transition from owner to retiree smoothly while maximizing the value of their biggest asset. One solution may be an employee stock ownership plan (ESOP). The ESOP can provide diver­si­fi­cation for the business owner and can be put in place well in advance of their retirement without giving up control. These plans were created in the Employee Retirement Income Security Act of 1974 so they have been around for a long time and the rules are well estab­lished.

An ESOP is a qualified defined-contribution retirement plan much like a profit-sharing plan. The big difference is this plan invests primarily in the stock of the company. The plan allows the company to borrow money to buy the stock from the owner(s). Owners selling their stock in C Corpo­ra­tions to the ESOP can reinvest the proceeds of the sale in other securities without incurring the gain for tax purposes once the ESOP owns 30% of all the shares in the company. They simply transfer their cost basis in the company to the new security they purchased in a like-kind exchange and defer the gain until the new security is sold. Thus the owner has diver­sified their assets without immediate tax conse­quences.

The owner isn’t required to sell their entire stake in the company through the ESOP. A sensible approach would be to offer 30% of the company shares to the plan. This amount would be an important first towards diver­si­fi­cation while still maintaining majority ownership of the company. The owner continues to partic­ipate in the growth of the company through the 70% of shares they still own. However, if the company were to decline in value, they have reduced their downside risk by locking in the value of the shares sold to the ESOP. As the loan is paid down and retirement nears, another 30% can be sold to the plan in a second-stage trans­action.

Shares in the ESOP are allocated to employee accounts much like the employer’s contri­bution to a 401(k) plan. The allocation can be made either on the basis of compen­sation or some more equal formula. Employees acquire increasing rights to the shares in their ESOP account through vesting based on the length of time they work for the company. ESOP rules require employees be 100% vested within three to six years depending on the vesting schedule chosen by the employer. If the employee leaves the company after they have vested shares, the company must buy back the shares at its fair market value if the stock is not publicly traded. Private companies are required to have an annual valuation to determine the fair market value of the stock.

Contri­bu­tions of stock to the employee’s account are not taxable. The tax is due only when they take a distri­b­ution and then at poten­tially favorable rates. The employee has the option of rolling over their distri­b­ution to IRA or other qualified retirement plan. Cash distri­b­u­tions from an ESOP are taxed as part ordinary income and part capital gains based on the accumu­lated growth after the stock is allocated to them. The ordinary income tax portion of the distri­b­ution will be subject to a 10% penalty if made before normal retirement age.

ESOPs are not for everybody. They cannot be used in partner­ships and most profes­sional corpo­ra­tions. ESOPs in S corpo­ra­tions have lower contri­bution limits and do not qualify for the in-kind tax treatment when the owner sells their shares to the plan. An ESOP is a qualified plan and the cost of estab­lishing one and maintaining it with annual valua­tions can be cost prohib­itive. The costs of running the plan and impli­ca­tions of diluting the owner’s share of the company will need to be weighed against the tax and diver­si­fi­cation benefits. Another benefit to consider is the positive impact on your employees when they are given the oppor­tunity to partic­ipate in the success of the company. You should consult an adviser experi­enced with estab­lishing ESOPs to determine if this solution may help you achieve your long term goals for retirement and your company’s future.

Rick’s Insights

  • An ESOP can provide diver­si­fi­cation for the business owner by allowing them to sell a portion of their ownership over time.
  • ESOPs are qualified defined-contribution retirement plans offering tax benefits to the owner and their employees.
  • The cost of estab­lishing and operating an ESOP can be prohib­itive and must be weighed against the tax and long-term benefits.