An ESOP is a qualified retirement plan funded primarily with the stock of that business. As an enticement for business owners to “share the wealth” with their employees, Congress has provided ESOPs with 3 key tax advantages.
ESOP Tax Advantages
- Under certain circumstances, the business owner can sell the stock and defer the tax on the gain.
- If the ESOP was established with funds from a third party financial institution, both the interest and principal payment s may be deductible.
- If the company is an S-Corp, income generated by the ESOP may be tax deferred
ESOP Versus 401(k)
The main difference is that a 401(k) is generally funded with the employees’ own pre-tax contributions and potentially an employer match. The ESOP is funded 100% with employer/business contributions. Much like a 401(k) there is no guarantee the company and the Plan will be a good investment, but because there is no cash outlay by the employee, there is seemingly little downside for the employees. The major ESOP downside may be failed expectations and delusions of grandeur that too often result in employees suing the company, the attorneys, the valuation experts, the trustees, and anyone else seemingly involved with the ESOP. The expectation of litigation is one of the reasons ESOPs are complex and expensive.
Because both are qualified plans, both an ESOP and 401(k) can be in place at the same time, assuming the company has the financial wherewithal to do it. The main issue with the ESOP is that its investment depends on the performance of a single company in a single industry. So if the company does poorly after the owners get their cash out, litigation against all parties can be expected.
ESOP Costs – It’s Expensive
An ESOP will likely cost $150,000 and could easily cost $250,000 up front, just to initially establish. Annual cost will continue throughout the life of the ESOP. You can expect continuing tax compliance, ERISA compliance, costs for extra tax returns, and annual business valuations, etc. An ESOP is not for an owner who just wants a simple exit. For an ESOP to be cost effective, you need to have a company that has at least 40 employees and annual sales in excess of $5 million.
Is the Owner ready to Open the Books
At the very least, the business owners will have to allow employees access to the annual valuation of the company. As news owners, with perceived “chips in the game”, most employees will demand greater access to company financials throughout the year. Accordingly, time, effort, and money will need to be spent teaching employees to be more financially literate.
Many business owners have become accustomed to making decisions by themself and don’t like sharing information with employees. ESOPs are generally not a good fit in this atmosphere. Business owners who like the idea of getting employees involved in decision making and are willing to get more people involved in the decision making process, should explore the ESOP as an exit strategy.
Does the Business Expect Growth?
Through an ESOP, employees will become beneficiaries of the stock value of the company. If the company isn’t growing and doesn’t increase in value, the ESOP will become a negative in the eyes of the employees and potentially doom the company. Accordingly, ESOPs should not be undertaking merely for financial or tax benefits. The makeup and drive of the employees, the business, the industry, and the total chemistry and potential synergies must be considered. The company must have a well trained and experienced management team in place that can lead the company to continued and sustained profitability. The company should also have the training in place to attract and create the next generation of management.
ESOP – Not a Quick Exit Strategy
If you are in a hurry, the ESOP strategy is not for you. The ESOP takes many years, sometimes more than 20 years to complete the sale of the company to the ESOP. Time should be available to unwind the ESOP if it’s not working out. You must have time, patience, energy, and the money to make the Plan work.
Additional Issues – Talking Points
- ESOPs have repurchase obligations. Employees can require the ESOP to repurchase their stock when they leave the company. This is out of control of the company management and may create cash flow issues and obligate the company to hamper the balance sheet and create and carry funds for current and future repurchase obligations.
- ESOPs are difficult to unwind. The unique structure of the ESOP makes it incredibly complex and expensive to unwind or sell a company with an ESOP.
- Raising equity capital for an ESOP company may also be very problematic.
So What’s the Best Answer
The best answer is get an objective and thorough analysis and education of all succession, exit, business, and tax planning options that are available to you, the business owner. Promoters are quick to sell the positives and business owners can become fascinated with the theory of an ESOP without fully understanding the complexities, costs, and risks.
Your Business Exit Strategy
You should only implement your Exit Strategy after thoroughly and objectively educating yourself on all business, tax, and legal options for converting business wealth into personal wealth. ESOP should be a part of the discussion that includes all exit strategies -qualified and nonqualified retirement plans, management buyouts, defined benefit plans, sale to third party buyer, sale to family, or any other tax and business friendly method of exiting your business. Just remember, whatever method you choose, the IRS will be an interested spectator.
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The Business Wealth Preservation Group is a professional services firm dedicated to providing superior individualized and custom service to individuals and their businesses in the areas of asset protection, tax planning, exit strategies, and wealth building. Simply put – we want to educate you on all relevant opportunities to put more dollars into your pocket, your business and your future.
We focus on leading edge, sophisticated, and safe business strategies that will help business owners structure, operate and maintain their business to take advantage of business and tax laws rather than being encumbered by them. We partner with the business, the accountant, and the attorney to ensure the business owners are capturing all available benefits that align with their business and personal goals.
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