Give Your Employees Ownership—Literally

Mark Battersby

In addition to being an excellent exit strategy with significant tax savings for a retiring owner, shareholder or members of the businesses, Employee Stock Ownership Plans, or ESOPs, are great for motivating and rewarding employees—and for taking advantage of incentives to borrow money for acquiring new assets in pretax dollars.

Almost unknown until 1974, today, many businesses are using ESOPs for a variety of purposes other than the succession planning they’re most closely associated with. But launching an ESOP isn't just about benefiting the business owner—most growers and retailers willing to go to the trouble of implementing such a plan also have the interests of their employees and the business in mind.

ESOPs 101
Employee ownership in a commercial growing business can be accomplished in a variety of ways, but the most common form of employee ownership in the U.S. is the ESOP.

Most often, an ESOP is a qualified retirement program in which employees receive shares of the business rather than stock. ESOPs are said to be “qualified” because they qualify for federal income tax deferral until the stock is turned into cash at retirement.

When it comes to employers, an ESOP offers two key advantages. First, the business gets significant tax breaks. It can, for instance, borrow funds through the ESOP that can be used for expansion or other purposes, deducting both the repayment and interest when the loan is repaid.

With ordinary loans, only interest payments are tax deductible. In addition, the grower/retailer who sells his or her stock to the ESOP can defer, or often even avoid, the capital gains taxes usually associated with the sale of the business. With these essentials, ESOPs have become an important tool in succession planning for business owners preparing for retirement.

However, in addition to being an important succession planning tool for grower/retailers thinking about retirement, the operation’s employees also can benefit from an ESOP. From the viewpoint of the operation’s employees, ESOPs are in most respects similar to 401(k) plans except that, instead of cash, the business providing the ESOP “pays in” shares of its own stock. But, as in 401(k) plans, all full-time employees meeting certain age and service requirements must be eligible. However, unlike a 401(k) plan, employer contributions to an ESOP do not become the property of the employee until after specified vesting periods are satisfied.

Under both an ESOP and a 401(k) program, employees receive monetary benefits on retirement or in the event of death or disability. The chief difference is that with a 401(k) the funds paid in are invested in a diversified portfolio; in the ESOP, they hold only the operation’s own stock. The advantages and risks of ESOPs derive from this difference.

Buying and selling a business
An ESOP is also an extremely useful tool when it comes to buying and selling the business. In fact, an ESOP is an excellent tool for selling a minority interest in a commercial growing business. By selling a portion of their business, a grower can invest the sale proceeds in other assets to provide much-needed wealth diversification.

Naturally, a business owner nearing retirement age can sell his or her stake in the business to the ESOP in order to gain tax advantages and provide for the continuation of the business. According to many experts, transferring ownership to the operation’s employees in this manner is often preferable to a sale to a third-party.

After all, third-party sales have negative tax implications if successful. Buyers may be difficult to find, and after the transaction, collecting installment payments may turn out to be difficult or costly. With an ESOP, more certain results are possible.

The ESOP can borrow money to buy out the owner’s stake in the business. If, after the stock purchase, the ESOP holds more than 30% of the business’s shares, the owner can defer capital-gains taxes by investing the proceeds in a Qualified Replacement Property (QRP). QRPs can include stocks, bonds and certain retirement accounts. The income stream generated by the QRP can help provide the departing business owner with income during retirement.

ESOPs can also prove helpful to those interested in buying a small business. Many individuals and businesses have raised the capital to finance purchases or acquisitions by selling non-voting stock in the business to its employees. This strategy allows the buyer/purchaser to retain the voting shares, all the while maintaining control of the business.

Major tax benefits

ESOPs have a number of significant tax benefits, the most important of which are:

1. Contributions of stock are tax deductible: That means a business can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP, although this means the interests of existing owners will be diluted.

2. Cash contributions are deductible: The business can contribute cash on a discretionary basis year-to-year and take a tax deduction for it, whether the contribution is used to buy shares from current owners or to build up a cash reserve in the ESOP for future use.

3. Contributions used to repay a loan the ESOP takes out to buy shares in the business are tax-deductible: The ESOP can borrow money to buy existing shares, new shares or treasury shares. Regardless of the use, the contributions are deductible, meaning ESOP financing is done in pretax dollars.

4. Sellers in a regular C corporation get a tax deferral: With an incorporated business, once the ESOP owns 30% of all the shares in the business, the seller can reinvest the proceeds of the sale in other securities, deferring any tax on the gain.

5. In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually not at the state level): That means there’s usually no income tax on 30% of the profits of an S corporation with an ESOP holding 30% of the stock, and no income tax at all on the profits of an S corporation wholly owned by its ESOP. However, the ESOP still must get a pro-rata share of any distributions the business makes to owners.

6. Dividends are tax-deductible: Reasonable dividends used to repay an ESOP loan, passed through to employees or reinvested by employees in the business’ stock are tax-deductible.

7. Employees pay no tax on the contributions to the ESOP, only the distribution of their accounts, and then at potentially favorable rates: The employees can roll over their distributions in an IRA or other retirement plan or pay current tax on the distribution, with any gains accumulated over time taxed as capital gains. The income tax portion of the distributions is, however, subject to a 10% penalty if made before normal retirement age.

Not too surprisingly, all contribution limits are subject to certain limitations, although these rarely pose a problem for a well-advised commercial growing business—or its owner, shareholders or members.

Beware the ESOP
As attractive as these tax benefits are, however, there are limits and drawbacks. The tax laws do not, for instance, allow ESOPs to be used in partnerships or most professional corporations. ESOPs can, of course, be used in S corporations, but don’t qualify for the unique rollover treatment accorded those ESOPs using regular corporate entities and have lower contribution limits.

Privately-held commercial growing businesses are, for example, required to repurchase the shares of departing employees and this can become a major expense. The cost of setting up an ESOP is also substantial—as much as $40,000 for a simple, basic plan for a small business, quickly rising based on the size of the business and number of employees involved.

Reportedly, only about two-thirds of ESOPs are used to provide a market for the shares of a departing owner of a profitable, closely-held business. Most of the remainder are used either as a supplemental employee benefit plan or as a means to borrow money in a tax-favored manner. Even more surprisingly, less than 3% of ESOP plans are in public companies.

That’s right—whether used either as a supplemental employee benefit plan or as a means to borrow money in a tax-favored manner, ESOPs are more than a tool for retiring grower/retailers … or a path to easing their way out of the business. GT

Mark Battersby is a freelance writer who specializes in business finance. He can be reached at mebatt12@earthlink.net.