In an ever-changing and challenging economic and political environment, companies face a multitude of issues including, but not limited to, maximizing shareholder wealth, transferring stock ownership, minimizing taxes, managing cash flow, retaining and attracting employees, etc. An Employee Stock Ownership Plan (ESOP) structure is an excellent avenue to explore to help navigate and manage these challenges. An ESOP provides a structure where employees earn an interest in the ownership of the company over time. This ownership interest serves as a valuable tool to align everyone at all levels within the company to drive overall performance and stock appreciation.
What is an ESOP structure?
This structure is the most common way for employees to earn and retain ownership in a company. An ESOP is like a traditional 401(k) plan in that it is a qualified retirement plan. Under an ESOP, the company’s shares are transferred into a trust administered by trustees for the benefit of the employees. The value of the stock held by the ESOP is determined annually by an independent appraiser based on the company’s financial health and overall performance.
What can an ESOP structure be used for?
ESOPs are a powerful tool for current ownership looking to move on from the company and transfer ownership to the next generation. Owners of privately held companies can use an ESOP to create a ready market for their shares. Under this approach, the company can make tax-deductible cash contributions to the ESOP to purchase an owner’s shares, or it can have the ESOP borrow money to buy the shares. An ESOP has the ability to borrow cash, which can be utilized to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan. Alternatively, the company can simply issue new shares or treasury shares to an ESOP, deducting their value (for up to 25% of covered pay) from taxable income. The company may also contribute cash to buy shares from the existing owners.
What are the major tax benefits of an ESOP structure?
The contributions of stock and cash to an ESOP are deductible. The issuance of new shares or the release of shares from treasury to the ESOP results in a tax-deductible contribution. However, this will result in the dilution of ownership. Companies are also able to contribute cash on a discretionary basis. This cash can be used to buy shares, or it can be retained for future use by the ESOP.
Also, contributions to the plan that are utilized to repay a loan the ESOP incurs to buy shares are deductible.
The employees that own the stock in an ESOP pay no tax on the contributions made by the company and the value of the stock grows tax deferred. The employees can roll over their share of ESOP shares into a qualifying retirement plan (like an IRA) tax free.
In S-Corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually the state level as well). The ESOP is essentially a tax-exempt owner. For example, if the ESOP owns 30% of the S-Corporation, there is no income tax on 30% its profits. An S-Corporation wholly owned by its ESOP will not be subject to income tax. in the partial ESOP ownership of the S-Corporation example, the ESOP would receive a pro-rata share of any distributions the company makes. The cash from these distributions will enable the ESOP to fund stock purchases, pay down debt, etc.
In the case of a C-Corporation structure, the owners selling stock to the ESOP can get a tax deferral by exchanging the C-Corporation stock in their company for shares of another C corporation. The seller can also choose to reinvest the proceeds of the sale in other qualifying securities and defer any tax on the gain. This type of transaction falls under Section 1042 of the Internal Revenue Code. A Section 1042 transaction requires a C-Corporation structure and the owner to sell at least 30% of the company’s stock to the ESOP. After the transaction, the owner must identify qualified replacement stock within a 15-month period.
How can an ESOP impact employee motivation and productivity?
As the employees gain stock ownership within the ESOP, the employees gain a vested interest in the success of the company. The employees have a direct stake in the company’s performance aligning the interests of all levels of company ownership with the common goal of enhancing value. The vested interest in the company’s performance leads to improved company culture. Also, employees participating in an ESOP can foster greater levels of innovation and are typically more motivated to advance the company’s value. The ESOP structure also increases retention amongst the employees due to them having a vested interest and corresponding retirement benefit. The retirement benefit provides a great sense of security to the employees especially if the company also provides a traditional retirement plan, such as a 401(k). This use of an ESOP structure paired with a traditional plan offers employees two retirement plans to ensure their efforts are incentivized and will be available for a transition into their next phase of life.
How can HBK help?
HBK CPAs & Consultants has advised and consulted in a wide range of ESOP transactions. If you are looking to transition ownership and provide for employee retention, an ESOP structure can be a powerful tool. A corresponding benefit of the ESOP structure is the substantial tax benefits. Given the political uncertainty, rising U.S. deficits and the potential for increasing tax rates, the ESOP structure can serve as a potential safety net. Please contact HBK Manufacturing Solutions at manufacturing@hbkcpa.com or 330-758-8613 to start the discussion.
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