Planning an exit strategy from your successful architecture or engineering firm can be difficult at times. While there are many options to choose from, one that many companies fail to consider is an Employee-Owned Stock Ownership Plan, or ESOP.
An ESOP is a tax-qualified retirement plan that is subject to the Employee Retirement Income Security Act of 1974 (ERISA) requirements. The main difference between an ESOP and other tax- qualified retirement plans is that an ESOP must invest in the company’s stock. ESOPs offer an owner a beneficial way to reward loyal employees while transferring ownership.
How do ESOPs Work?
The ESOP trust must be formed by the business with a trustee who is typically independent of the business. All or a portion of the company is purchased by the ESOP from the owner(s) after an appraisal of the business is performed. In many cases, the business must borrow funds from an outside lender, and the loan proceeds are immediately distributed to the ESOP as an internal loan for the ESOP to purchase the shares or interest of the business. Outside lenders require this two-step loan process to avoid compliance issues with ERISA loan requirements.
If the purchase is only partially financed with outside debt, the remaining interest could be funded by seller or owner notes calling for a reasonable interest rate while remainingsubordinate to the outside financing. Many owners find this type of financing appealing since they receive a favorable rate of return on the note.
Businesses are required to make tax-deductible contributions annually to the ESOP. The contribution gives the ESOP funds to repay the internal loan that the ESOP has with the business.
In addition, C corporations can pay tax-deductible dividends, while S corporations can make distributions on stock shares held by the ESOP to help pay down the internal loan.
Shares purchased by the ESOP are held in an account within the trust. As the internal loan is paid down, shares of stock are released from this account and allocated to participating employee accounts. This can be based on the number of years of service the employee has or some other formula for participation. Though rules vary, employees are typically fully vested in three to six years.
Advantages of ESOPs
ESOPs effectively create an internal market for the interest or shares in the business, giving the owner an option for liquidity. They provide a range of tax incentives and tax deductions, with the owner able to defer the transaction’s taxes in many cases. Shareholders in a C corporation can defer taxes by reinvesting proceeds into the securities of outside domestic companies. S corporations and partnerships may be changed into a C corporation prior to the sale for the same tax deferral benefits.
If the company remains an S corporation, there is the benefit of not having to pay federal taxes on the shares held by the ESOP due to the pass-through rules. At the employee level, the shares within the ESOP trust allocated to employee accounts accumulate on a tax-free basis until disbursement.
Does an ESOP Make Sense for You?
For many owners, an ESOP might be an ideal solution. However, there are many considerations to take into account to ensure an ESOP will work well for your business. Be sure to consult with your CPA to determine if an ESOP would be a good option for your business.
