Win-win
An Employee Stock Ownership Plan (ESOP), is the most popular form of employee ownership in the U.S. ESOPs helps businesses establish a transition plan by creating a market for their company’s stock. This method of ownership transfer or sale can be a sound strategic move for business owners to ease the burden of retirement and to sell in a way that is advantageous for tax purposes. The benefits of an ESOP are not mutually exclusive, it is also a great way to spread the wealth amongst dedicated employees and promotes an ownership culture within a company, making this a win-win benefit plan. After all, giving employees a sense of ownership can make them feel like an important part of the company, incentivizing them to work harder and fostering loyalty and productivity.
The implementation of an ESOP can be extremely complicated, Matthew Rossetti is an expert in this area of practice and will confidently guide you through the process. Let’s take a deeper look into it to determine if an ESOP is the best option for your company.
ESOP simplified
Stock options give employees the opportunity to own parts of the company they work for. In an employee stock option plan a company sets up a trust and this trust can acquire, hold, and sell the company’s stock. An ESOP (employee stock ownership or employee share ownership) is a kind of employee benefit plan offered by employers. In most cases, ESOPs are a contribution made from the company to the employee, rather than an employee purchase. It is a defined-contribution (employees do not pay income tax on the amount contributed by their employer until they withdraw money from the plan) similar to profit-sharing or a 401(k) employee benefit retirement plan. Company shares are allocated to individual employees’ accounts annually. Upon retirement, disability, termination, or death the employer must buy back the stock at fair market value from the employee unless there is a public market for the shares.
With an ESOP an owner of a company can sell parts or all of its shares and continue to maintain control of the company and its business operations. It is important to note, while this plan is referred to as employee stock ownership, the employees don’t actually own stock in the company. The ESOP is an organized retirement account, held by a trustee for the benefit of the employee. That person, or trust company, will negotiate a closing deal on behalf of the employees and hold the sold stock in trust. Although employees have an ownership stake in the company, they don’t actually have a right to vote the shares, to elect the board of directors, or any say as to how the company should or will be operated. When the employees retire, then, they reap the rewards and get a payment based on what the shares are worth.
Why is it advantageous to an employer?
Choosing to sell a business to an ESOP requires much consideration for a business owner. While establishing an ESOP has its advantages, an ESOP is not the proper course of action for all corporations, and particular entity formations do not meet the requirements for this type of employee benefit plan. For example, an S corporation and a C Corporation have the ability to establish an ESOP. However, an LLC is not permitted to have an ESOP because it does not have stock, it has memberships or units, therefore it can not offer ESOP stock options. That being said, an LLC that is taxed as an S corporation does qualify for an ESOP. Rather than stock, the unit shares will have the same rights to distribution, dividends, and liquidation proceeds.
For those companies that do qualify and opt for an employee stock option plan, there are substantial tax advantages. Not only is it a tax-exempt trust, transferring to an ESOP allows a business owner to defer or bypass capital gains taxes. Moreover, contributions of stock and cash are tax-deductible, and when an ESOP is used to borrow money both the loan repayments and interest are tax-deductible. The benefits of an ESOP will vary depending on the type of entity a business owner chooses for their company. Many companies choose to convert LLC taxed partnerships into an LLC taxed as a corporation, S corporations into C corporations, and C corporations into S corporations after having more clarity as to the benefits of each. A popular choice of entity selection for businesses aiming to offer an ESOP is choosing an S corporation, due to its significant tax advantages.
If the ESOP holds shares in an S corporation, the earnings from the ESOP shares are not taxable. Furthermore, an S corporation can avoid tax distributions all together and hold on to the cash in the company, for reinvestment into the business, if the ESOP owns 100 percent of the company. This is because S corps don’t pay tax on their profits, their profits and losses are passed through to their shareholders based on the percentage of their ownership. If an ESOP owns the company, there is no federal tax due because the ESOP is in a trust, which is tax exempt, allowing companies to retain more of its earnings. With the increase of cash flow, corporations are able to quickly reduce debt, enhance employee benefits, and have funds for greater capital investments and acquisitions. This is a huge tax advantage for S corporations. Do keep in mind, Any changes that are to be made to your business entity should be done after consulting a qualified attorney, due to possible adverse consequences.