If you’re like many successful entrepreneurs, a significant amount of your personal wealth consists of your ownership interests in the company you’ve built. If you are nearing retirement, you may have begun struggling with the issue of how to convert some or all of those ownership interests into cash without selling the company outright.
Selling your company may not be appealing because of the tax considerations, your desire to protect your employees and your interest in continuing to be involved with the firm. For many entrepreneurs, creating an employee stock ownership plan, or ESOP, may be an attractive option.
Weigh the benefits of an ESOP. An ESOP is a tax-qualified retirement plan — like a 401(k) plan but funded solely through employer contributions, not staff salary deferrals — that’s designed to invest primarily in the company’s stock.
The Internal Revenue Code contains numerous tax incentives for companies that adopt ESOPs and owners who sell their stock to the plan.
The most significant of these tax benefits is that the ESOP can borrow money for the purchase of company stock and the firm can pay back the borrowed funds with tax-deductible contributions to the plan. (This is known as a “leveraged ESOP.”)
If the company is a C corporation and the ESOP buys at least 30 percent of the value of the firm (and other requirements are met), the owners of the company can sell their stock to the plan on a tax-deferred or, in some cases, tax-exempt basis.
There are also valuable tax benefits for S corporations that set up ESOPs.
Understand the players involved. If your company adopts an ESOP, the players will include the trustee of the trust created to hold the company stock for plan participants, the lender, the firm’s owners who are selling their stock to the plan and the employees who, if they satisfy the vesting requirements, will receive the value of the firm’s stock allocated to their accounts when they retire.
Figure out whether your company is a good candidate. First consider if your company is large enough to justify the costs involved in establishing and operating an ESOP.
If the value of the stock you’re planning to sell to the ESOP is not at least $2 million to $3 million, an ESOP is probably not a good option for your firm.
If your company is worth just $2 million or $3 million, you would likely need to sell all the stock to the ESOP to make it worthwhile.
If your company is worth $10 million or more, a sale of just 30 percent of the stock would be sufficient. (Thirty percent is the amount necessary to take advantage of the tax-deferred-sale tax incentives for C corporations.)
Second, if you are planning to create a leveraged ESOP, be sure you have a large enough payroll to make sufficient contributions to the ESOP to repay the ESOP loan. Tax rules limit the amount that can be contributed to the ESOP to repay the loan to a percentage of participants’ compensation.
Federal laws require that the purchase of employer stock by the ESOP be a prudent investment. If, because of issues unique to your company or its industry, the prospects for your firm are not good, an ESOP is not an appropriate option. Part of this analysis involves whether competent management will be in place to operate the company as your involvement is phased out.
Most successful ESOPs have been implemented not just for the tax and financial benefits but also to reward and encourage employee efforts on behalf of the company.
Calculating the cost of setting up a plan. Because of the complexity of the rules involved and the need to retain qualified advisors, implementing an ESOP can be expensive.
For a leveraged ESOP transaction, the costs typically run from $125,000 to $250,000, depending on the size of the transaction and the type of financing. Keep in mind, however, that an outright sale of the company would also entail comparable costs.
Getting a plan started. The first step is to engage an independent valuation firm and other ESOP professionals. The independent valuation firm will conduct an initial feasibility study to ensure that an ESOP is a viable financial option for your company.
Professionals involved in an ESOP’s setting up include trustees, accountants, attorneys and financial advisors. Because of the complexity of the rules, consider engaging professionals with significant experience working with ESOPs.
Once the feasibility study is completed, you will be ready to take the additional steps required to fully set up the ESOP, including adopting the official documents, finalizing its financing and negotiating the sale of the owner’s stock to the plan.