John Fitzgerald, CPA, and Stanley E. Bulua, Esq.
10.25.21 | Berdon Vision
In need of an exit strategy? An Employee Stock Ownership Plan (ESOP) might be the answer.
After a lifetime of building a business from the ground up, business owners often find that one of their last hurdles before a well-earned retirement is also among the most difficult they have to face: Choosing an exit strategy that both protects their investment and allows their life’s work to continue into the future.
There is a multitude of exit strategies that proprietors of closely held businesses have traditionally turned to as they contemplate that final push toward a financially secure retirement.
Choosing Your Exit Strategy
There are many popular exit strategies that small and medium-sized business owners consider before retiring. Successful succession plans will typically involve:
a) a merger,
b) an acquisition,
c) selling the business to a partner, family member, or long-time employee, or
d) an initial public offering, thereby taking the enterprise public.
Considering the ESOP Alternative
An increasingly popular alternative to these strategies is the ESOP, which involves the sale of the business to a retirement trust that ultimately results in a trust for the benefit of the employees owning the stock in the company. An ESOP differs from traditional exit strategies in that it can tackle more than just the issue of succession planning. ESOPs can assist a business owner in a myriad of ways, including estate planning, tax savings, and retirement planning.
And ESOPs are becoming increasingly popular. According to the National Center for Employee Ownership:
- In 2018, 252 new ESOPs were created, covering more than 31,000 participants.
- In total, there are approximately 6,501 ESOPs in the United States, holding total assets of over $1.4 trillion. The number of unique companies with an ESOP is approximately 6,272 (a company may sponsor multiple plans).
- ESOPs cover over 14 million participants, of whom 10.3 million are active participants—those currently employed and covered by an ESOP.
Manufacturing, distribution, and retail companies that have adopted ESOPs are among the largest businesses in the country and include Publix Super Markets, Brookshire Brothers, and WinCo Foods.
The ESOP Advantages
It is not hard to fathom why ESOPs are increasingly popular. Choosing an ESOP allows small to medium-size business owners to create and plan for a dual legacy: One for their family and one for their employees. It provides business owners the opportunity to diversify their wealth in a tax-advantaged manner. At the same time, it creates a financial incentive for the company employees to expand and increase the profitability of the business by allocating shares held by the ESOP in the company over time to the accounts of individual employees.
An Attractive Tax Strategy
ESOP strategies are increasingly attractive to small and medium-sized businesses (SMEs) and companies in manufacturing, distribution, and retail because of the tax benefits that accrue to both owners and workers.
ESOPs provide substantial tax advantages whether your small to medium-size business is an S or a C corporation. Under certain circumstances, for C corporations only, the owner benefits from paying no capital gains on the sale, and the company benefits because an ESOP is permitted under the Employee Retirement Income Security Act of 1974 (ERISA) to borrow money from the company to finance the purchase of the outstanding shares. Still more, ESOPs allow companies to repay this debt in pre-tax dollars, effectively providing the company with tax deductions equal to the purchase price of the ESOP shares. If your business is an S corporation, provided it is 100% owned by the ESOP, the company will not pay any federal and state income tax, depending on the jurisdiction, because the ESOP trust is a tax-exempt entity. If the business is partially owned by the ESOP, a proportionate share of the company’s earnings will not be subject to income tax.
More Pros and Cons to Consider
Financial advisors seem to be in agreement that one of the hurdles they face in pitching an ESOP strategy is that it is complicated. An ESOP is no mere buy/sell transaction. It is easy, particularly for laymen, to get lost in the weeds of tax law as one contemplates the relative merits of moving from a C corporation to an S corporation to maximize the tax benefits of an ESOP.
Yet, the positives would seem to outweigh the negatives. ESOPs incentivize employees by giving them a stake in the ownership of the company. As the old saying goes: No one washes a rental car. When employees have skin in the game, they will stay for the long term and probably be more attentive to their work. And as the value of an ESOP increases, the benefits of retirement increase.
Given the tax advantages, liquidity, incentives, and overall flexibility that come with choosing an ESOP, you owe it to yourself to talk with your attorney or CPA to see if an Employee Stock Ownership Plan will work for you.
This alert is for general information purposes only and is not intended, and should not be construed, as financial, legal or tax advice.
Questions: Contact John Fitzgerald at 212.331.7411 | JFitzgerald@berdonllp.com or Stanley E. Bulua, Partner at Robinson Brog Leinwand Greene Genovese & Gluck, P.C., at 212.603.6311 | SBulua@robinsonbrog.com.
Berdon LLP New York Accountants