• Vinicius Adam

Employee Stock Ownership Plans (ESOP), not to be confused with Employee Stock Option Plans

If you have recently spoken with your attorneys, accountants, business advisor, or wealth manager about selling your business in anticipation of retirement, you probably discussed an Employee Stock Ownership Plan (ESOP) as an alternative to sale on the open market. Do not confuse the Employee Stock Ownership Plan with the Employee Stock Option Plan, which allows employees to purchase the company’s stock at a set price over time and is not a retirement plan.

An ESOP contemplates selling the company to all qualified employees as an employee benefit. It can also be used to fund the sale by placing the stock in trust which the employees buy over time or for which financing is obtained resulting in an immediate sale. When the stock placed in trust is purchased over time, the sale is financed by the seller who gets installment payments (principal and interest) pursuant to a promissory note. The price of the stock is set up by an independent business appraiser. However funded, the ESOP is a vehicle to use this money to purchase the business owners’ stock.

As the stock is purchased by the ESOP, participating employees indirectly own the stock purchased by the Plan. The ESOP holds the stock for the benefit of the employees for as long as they work for the company. The company re-purchases the employees’ interest in the stock at fair market value (which requires another appraisal) as they retire or resign from the company, which requires the company to have cash reserves. These shares are then redistributed.

There may be several tax benefits to ESOPS. Capital gains tax may be deferred if it is structured correctly as a tax-qualified retirement plan. Specifically, the owner may take the money from the sale of this stock and reinvest it in “qualified securities” and defer payment of capital gains tax until these securities are sold. The company also benefits as it can take deductions for the contributions to the Plan. Additionally, contributions made to the ESOP are tax free to the ESOP and the employees participating in the Plan.

There can also be significant costs setting up and maintaining the ESOP. In order to set up the ESOP, companies usually submit their employee stock ownership plan to the IRS with a request for a determination letter which confirms that the form of the ESOP satisfies the requirements of the Internal Revenue Code. Additionally, the Plan may have to be submitted to the Department of Labor. Once per year after the initial valuation, the company must be appraised in order to attach a value to the stock. in order to maintain its tax-qualified retirement plan status, recurring contributions must be made by participants and individual accounts must be maintained for each participating employee, which can be another challenge.

While the ESOP is not for every business owner, ESOPs can offer some major benefits to owners such as business continuity, deferred capital gains tax, and the ability to hand over your business to deserving employees. As business owners contemplate retirement, ESOPs are an option worth discussing with your attorneys and business advisors.