ESOPs: a tax-efficient way to reward employees and provide liquidity for shareholders

Steve Burke, Beth Fowler and John Bentas  for McLane Law and NHBR.com write:  We are in the midst of what may be the biggest transition of business ownership in history. Many business owners become frustrated with the process of marketing and selling their business, often feeling that the challenges of finding a buyer who will understand their business and continue the corporate culture insurmountable. An employee stock ownership plan, or ESOP, can provide a solution.

An ESOP can be a valuable mechanism to reward employees, provide liquidity for shareholders and promote productivity and employee loyalty in your company. And this can be done in a tax-efficient manner.

An ESOP is a retirement plan that invests primarily in the shares of your company. A trust holds the shares for the benefit of the employees. The ESOP operates through a written plan and is administered through a trust. The plan governs the terms of participation, vesting, benefits and other matters.

The trust, through its trustees and agents, holds plan assets and administers the plan. The formation and administration of an ESOP can be complicated, but with proper guidance from professionals, the uses and benefits can far outweigh these complexities.

Studies have shown that ESOP companies provide greater retirement benefits than non-ESOP companies, have greater sales and sales per employee and are more likely to stay in business.

An ESOP can create a market for the shares of your company where one might not already exist, or when the outside market may not be palatable to the current shareholders.

There is some latitude in how an ESOP transaction can be structured, as opposed to more traditional transactions. In particular, the transaction can be structured to provide a gradual transition of the business from current owners to the ESOP trust.

In many traditional transactions, third parties have little interest in acquiring a minority position in a company. As a result, an ESOP can be an excellent tool for succession planning, both for liquidity and transition reasons.

A proper ESOP implementation can also encourage a culture within a company of participation and ownership. An ESOP can reward employees with company ownership whose value ties to company performance. Employees see the benefits of their work through increases in the value of their ESOP accounts as the value of the company shares increase. Owning stock through an ESOP allows employees to share in the growth of their company. This sense of participation and partial ownership promotes productivity and loyalty at all levels of employees.

Not for everyone

In addition to the liquidity and employee-related benefits, an ESOP can have significant tax benefits to the company, selling shareholders and the employee-participants.

An ESOP can use tax-deductible corporate earnings to buy shares from owners. When combined with a leveraged transaction, both interest and principal payments on the loan may be tax-deductible. This ability to partially offset the cost of funding a transaction with tax dollars is not available in most other forms of succession planning and business acquisitions.

In some instances, the selling shareholders may be able to defer taxes on the sale of shares by completing a tax-free exchange of the sale proceeds into other assets.

Because an ESOP is a defined contribution plan, the employee-participants do not recognize any gain on the value of their allocated stock until their employment terminates and they cash out. Even then, they may be able to roll over the account balance into another tax-deferred retirement account.

Moreover, an employee does not pay anything out of his or her pocket to get this benefit.

If an ESOP has all these great benefits and advantages, why do not all closely held companies implement one? The simple answer is that an ESOP is not ideal for all companies.

Because the ESOP will have future obligations to repurchase shares when employees terminate employment for any reason, an ESOP works best for a company with enough free cash flow or a relatively steady or predictable revenue stream to help plan for these future obligations. Businesses with a high degree of employee turnover may not benefit from the pro-employee aspects of an ESOP. The costs to implement and administer an ESOP can also be a factor to consider.

Notwithstanding those concerns, many small and medium-sized businesses, and even some publicly traded companies, have found ESOPs to be a valuable tool. The same may hold true for your company.

But an ESOP should be a consideration for any closely held company considering succession planning or transition of its management and control to executive-level employees, ways to reward employees for their contributions to the company over time, or measures for increasing productivity and loyalty of its workforce.

Studies have shown that ESOP companies provide greater retirement benefits than non-ESOP companies, have greater sales and sales per employee and are more likely to stay in business. ESOPs are a path to personal and business security that deserve your serious consideration.