For the owners of many privately held businesses, succession planning can be a conundrum.
While many business owners would like their children or management employees to eventually own and operate the companies they have built, the inability to finance a buy-out or lack of interest in stepping into an ownership role are often obstacles that prevent this from coming to fruition. If sale to a competitor or financial buyer is not a good option for whatever reason, an ESOP might be the answer.
An Employee Stock Ownership Plan is a type of employee benefit plan that owns equity securities of the company setting it up. Typically, the ESOP will obtain a bank loan to buy existing shares of the company from its owners, with the company making tax-deductible cash contributions to the ESOP to repay the loan. Shares held in the ESOP account are allocated to individual employee accounts that vest over time. Commonly, more highly compensated employees are allocated proportionately more shares to their ESOP accounts, which, together with other forms of equity compensation, can result in management employees owning a larger stake in the business, thus aligning them more closely with the long-term success of the business.
With an ESOP, owners can elect to sell shares all at once or over a period of years, and owners can maintain significant control even after selling a majority interest to the ESOP. This flexibility can be particularly attractive to owners who wish to remain involved while transitioning out of the business.
ESOPs also offer a number of significant tax benefits. Contributions of shares and cash to an ESOP are tax deductible, as are contributions made to the ESOP to repay loans it incurred to buy shares of the company. Owners selling shares of a C corporation can defer tax on any gain from the sale of shares to an ESOP if certain conditions are met. In the case of S corporations, any profits allocated to the ESOP are not taxed. Given these and other tax advantages of ESOPs, in addition to their benefits relating to business succession, ESOPs can have powerful tax planning implications.
While ESOPs will not work for every situation, when the time comes for business owners to review their options, they are worth consideration as a way to transition the business and reduce the risks associated with succession.
This post was written by George Thomas