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ESOPs Maximize Owners' Value
By: Robert A. CurtisIn planning for their own long-term financial security, business owners should consider the advantages of an employee stock ownership plan, or ESOP.
By establishing such a plan, owners can receive the maximum value of their holdings tax-free*, bequeath tax-sheltered funds to heirs and still maintain control of the company.
An ESOP is a retirement plan whose assets - shares in the company - are owned by the ESOP trustee for the benefit of the employees. When it's established, it borrows money to buy some or all of an owner's shares. The ESOP loan is guaranteed by the company, and the company services it with tax-deductible contributions. (Guarantee is based on the reliability of the company.)
When ESOPs Took Off
ESOPs have existed for years but became widely popular in the late 1980s, when many small and mid-sized businesses were being acquired by larger companies via tax-free stock swaps. The conglomerates moved or eliminated jobs in some locales and communities protested. Congress passed IRC Section 1042, which extended the tax benefits of a stock swap to ESOP plans.
By selling a business to an ESOP instead of a distant corporation, an owner can receive the same value and protect local jobs.
Tailor-Made for Manufacturers
Most ESOPs are leveraged, using borrowed money to buy stock from the selling shareholders. Thus, ESOPs are particularly attractive to companies with strong borrowing capacity - like manufacturers, whose physical assets stand them in good stead with lenders. Most distributors can also borrow an adequate amount.
Many owners of manufacturing and distribution companies have 80 or even 90 percent of their worth tied up in their business. An ESOP makes this wealth liquid and available for a more balanced investment portfolio.
Cash Value, Tax Protection, Control
An ESOP carries different tax advantages depending on the corporate form. In a C corporation, the seller can potentially avoid all capital gains taxes, a strong incentive to owners with little or no basis in company stock who would owe substantial tax on other kinds of sales. In order to receive this favorable tax treatment, the ESOP proceeds must be reinvested in compliance with IRC Section 1042. Be sure to discuss any tax matters with the appropriate professional.
To the extent an S corporation is owned by an ESOP, that proportion of the company's income is tax free*. So a 100-percent, ESOP-owned S corporation and its shareholders, could potentially pay no income tax.
Owners can maintain control in two ways. One, of course, is to sell less than half the stock. The other is to sell the majority of stock, but appoint a "directed" trustee of the ESOP. The directed trustee will vote its shares based upon direction from the ESOP committee, which is appointed by the board of directors. Control lies with the ESOP committee appointed by the company’s board of directors, which is elected by holders of voting stock.
Employee Education
At a company's first meeting to explain a new ESOP and its benefits, don't expect a standing ovation. Employees won't automatically understand or believe what the ESOP promises.
Some may focus on changes to their existing retirement plans, which normally remain in place. But since the company needs cash to service its ESOP debt, it will usually end its match of employee 401(k) contributions.
But if a company delivers the same explanations consistently, and employees see contributions coming in and their own accounts growing, fewer eyes will roll. When the first retiree receives a check, most employees become believers.
There are also creative ways to replicate the 401(k) match. For every dollar an employee puts in a 401(k), for example, the company could put a dollar of stock into the employee’s ESOP account. Such measures often result in increased employee contributions.
* May be subject to state, local and/or AMT taxes.
ESOPs offer great benefits, but they're not simple. We can help put together a team to properly assess this option with you. For more information, please contact Robert Curtis at robert.curtis@raymondjames.com, phone # 248.208.8511, or 2000 Town Center, Suite 1825, Southfield, Michigan 48075.The information has been obtained from sources considered to be reliable, but we do not guarantee that the foregoing material is accurate or complete. Any information is not a complete summary or statement of all available data necessary for making an investment decision and does not constitute a recommendation. Any opinions are those of Robert Curtis, CPA/PFS, MST, Branch Manager, RJFS; Managing Member, Clayton & McKervey Financial Group, LLC, and not necessarily those of RJFS or Raymond James. Expressions of opinion are as of this date and are subject to change without notice. Past performance may not be indicative of future.
Clayton & McKervey Financial Group, LLC. Registered Investment Adviser. Securities offered through Raymond James Financial Services, Inc. Member FINRA/SIPC.
