As the owner of a business, you have worked tirelessly to build a profitable company in which you take pride. Now, as you approach retirement, you may be looking for a suitable way to transfer the ownership of your business. An Employee Stock Ownership Plan (ESOP) is a way to maintain business continuity, preserve your legacy, increase employee engagement, and receive favorable tax treatment. An ESOP is one selling option to smooth the transition while at the same time benefiting yourself and your employees.
An ESOP transitions the ownership of a company by transferring company shares to the employees. In turn, employees become owners of the company. An ESOP is a type of retirement plan and, like a company’s tax-qualified retirement plan, is governed by the rules of the Employee Retirement Income Security Act (ERISA). Some well-known employee-owned businesses include Publix Super Market, New Belgium Brewing Company, and Mast General Store.
In order to establish an ESOP, the company sets up an ESOP trust, a legal entity established to hold shares for employees, and contributes money to the trust. Alternatively, the company can borrow the funds from a bank, the seller, or a combination of both. When the company borrows the money, the plan is called a leveraged ESOP. The trust then purchases shares (some, or all) from the owner. The price of the shares is determined by an outside appraisal of the company.
An individual account is set up for each employee who is eligible to participate in the plan. The trust then allocates company shares to the employee accounts. With a leveraged ESOP, shares are allocated as the loan is paid back. The shares are distributed among all eligible employees in a manner proportionate to the employee’s compensation (or by a formula which ensures a more equal distribution). The shares remain in the employee’s account until the employee retires or leaves the company, upon which time the employee cashes in the shares.
An ESOP not only provides obvious perks to employees, but it also provides numerous benefits to business owners looking to sell a business and retire.
Some benefits include:
- Employee engagement — An ESOP is a good alternative to finding an outside buyer for your business. By transitioning ownership to the existing employees, the employees are able to share in the value they are creating in the workplace, leading to more engaged employees who are invested in the success of the company. This means increased productivity and pride in the business. Moreover, this strategy can provide a significant retirement benefit to employees.
- Business continuity — Without the disruption of outside management taking over the business, an ESOP is a great way to preserve your legacy while smoothing the transition of ownership. An ESOP provides you as the business owner options for your role in the business as you ease into retirement. Even after transitioning ownership to your employees, you can continue working for the company.
- Favorable tax treatment — An ESOP may provide tax benefits to both the business owner as well as the business itself. First, the company’s contributions to the trust are tax-deductible. Second, if an S corporation is owned 100% by an ESOP, then the company does not pay income tax on profits since the income flows through to a tax-exempt trust. (If you are considering setting up an ESOP, work with your CPA to learn special tax benefits based upon your entity.)
Business owners considering the use of an ESOP in retirement should understand the limitations. In order to buy shares from the business owner, a company must generate enough profitability to continue conducting business. Also, business owners cannot be discretionary about which employees receive shares. Like other tax-qualified retirement plans, all employees who have worked at least 1,000 hours in a plan year must be included.
For the business owner of a profitable company nearing retirement who is looking for a way to ensure the continuity of your business operations, reap tax benefits, and increase pride and engagement among your employees, an Employee Stock Ownership Plan may be the right option for you. Always consult a CPA or attorney for the best advice for you.