ESOP, an Exit strategy for the company’s owner.
Owners of privately held companies can use an Employee Stock Ownership Plan (ESOP) to create a “ready market” for their shares. ESOP’s are the only retirement plans allowed by law to borrow money. They can be attractive to company owners as instruments of corporate finance and succession.
Typically, the company borrows money and then loans the ESOP trust fund for the purpose of acquiring shares. As the ESOP loan is paid down, shares are allocated to employee accounts annually, generally in proportion to the employee’s annual compensation.
One of the benefits is that the company can make tax-deductible cash contributions to the ESOP to buy out an owner’s shares, or it can have the ESOP borrow money to buy the shares. The company then makes tax-deductible contributions to the ESOP to repay the loan, both principal and interest being deductible.
The tax provisions of an ESOP can be a source of great benefits to a retiring owner. To qualify for tax deferral, once the ESOP owns 30% of all the share of the company, (s)he must buy other U.S. operating companies’ securities with the proceeds. When (s)he leaves those securities to her (his) heirs, the cost basis for tax purposes will be “stepped up” as of the date of death, and accumulated capital gains liability vanishes.
However, the ESOP has to keep its portion of the tax distribution to satisfy debt payments or repurchases of participant shares. In theory, if the ESOP owns 100 percent of the S corporation shares, the company can forgo tax distributions and retain the cash in the company to reinvest in the business. Over time, this enhanced cash flow can provide a company with a significant competitive advantage, allowing for accelerated reduction of debt, greater capital for investing, and enhanced employee benefits.
ESOP’s have a number of significant tax benefits, the most important of which are:
- ESOP financing is done in pretax dollars.
- Contributions of stock are tax-deductible: companies can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP. However, this means existing owners’ shares will be diluted.
- Cash contributions are deductible: a company can contribute cash on a discretionary basis and take a tax deduction for it. The contribution can be used to buy shares from current owners, to repay a loan the ESOP took out to buy company shares or to build up a cash reserve in the ESOP for future use.
- Sellers in a C corporation can get a tax deferral: once the ESOP owns 30% of all the shares in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain.
- In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level: with an ESOP holding 30% of the stock, there is no income tax on 30% of the profits of an S corporation. Note, however, that the ESOP still must get a prorata share of any distributions the company makes to owners.
- Dividends are tax-deductible: reasonable dividends used to repay an ESOP loan, passed through to employees, or reinvested by employees in company stock are tax-deductible.
Note that the law does not allow ESOP’s to be used in partnerships and most professional corporations.
I created this blog to help understand certain basic aspects of U.S. tax law. Of course, each situation is unique and nothing that is on this site will ever replace the expert advice of a tax professional.
Please do not hesitate to contact me should you have any question.