20 Apr ESOPs as Retirement Plans
Among the retirement plans that small businesses can offer to their workers are employee stock ownership plans (ESOPs). As the title indicates, an ESOP is a process for transferring ownership of the company to employees. How does that work as a retirement plan?
In some ways, an ESOP is similar to a profit-sharing plan, in which the company makes cash contributions. With a ‘vanilla’ or unleveraged ESOP, the company funds the plan by contributing shares of its stock or cash to buy those shares.
Uniquely among retirement plans, ESOPs can be leveraged. In one scenario, the ESOP borrows money from a financial institution or from another party, then uses the borrowed funds to purchase shares of the employer’s stock. Once the shares are in the plan, they are allocated to accounts of participating employees, generally all full-time workers 21 or older. Assuming the company’s shares are not publicly traded, annual independent appraisals track the value of the company’s shares, which in turn determine the value of each participant’s ESOP holdings.
Current law calls for gradual vesting of all employer contributions over a period of six years or complete vesting at three years. When employees leave the company, at retirement or sooner, they receive their vested shares. The employer is required to buy back the shares, at the currently appraised price. Therefore, a long-time ESOP participant could retire with a substantial amount from the plan.
Advantages to owners
Why should business owners consider an ESOP? Some studies indicate that employees become motivated to excel when they become employee-owners. They know that good corporate results will boost the annually appraised value of their shares and ultimately provide a bigger payout. Strong results will benefit major shareholders as well.
In addition, ESOPs offer some exceptional tax benefits to the sponsoring company and its principals.
Example 1: A local bank lends money to an ESOP, which uses those dollars to buy common stock from ABC Corp, the ESOP sponsor. Going forward, ABC makes tax-deductible contributions to the ESOP, which uses that money to repay the bank loan. With such an arrangement, ABC effectively borrows money through the ESOP, then deducts the principal and interest payments made on the ESOP loan, rather than just the interest payments.
In addition to such tax advantages, an ESOP provides a way for business owners to sell their shares at appraised value, if there are no other obvious buyers. In some situations, the owners may be able to defer taxes on a profitable sale of shares to an ESOP, perhaps indefinitely.
Example 2: Alice Baker sells 50 percent of her Alice Baker Co. stock to her company’s ESOP for $2 million. Her basis in those shares is $200,000, giving her a taxable gain of $1.8 million. Alice reinvests the sale proceeds in qualified replacement property, which includes stock in other U.S. corporations. Alice can defer tax on that $1.8 million gain until she sells her qualified replacement property.
If her company is an S corporation, however, Alice will not qualify for the tax deferral on the gain from the sale of her stock to the ESOP. However, ESOPs may offer other tax benefits to S corporations, such as tax exemption for any profits attributable to ESOP ownership.
ESOPs can be expensive
Business owners sponsoring ESOPs may realize advantages, but there are drawbacks as well. Payouts to departing employees for share buybacks can be a cash drain. The same is true for regulatory requirements, including annual appraisals. In addition, ESOP participants lack diversification in their retirement plans because the primary holding is the sponsoring company’s stock. Therefore, companies that sponsor ESOPs also may offer a retirement plan such as a 401(k), where employees can defer some of their salary (and the tax on that income) to acquire other investments.
If the idea of using an ESOP as a retirement plan appeals to you, our office can help you evaluate the costs and the potential benefits.