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 like a profit-sharing plan, in which the company makes cash contributions. With a “vanilla” or unleveraged plan, the company funds the plan by contributing shares of its stock, or cash to buy those shares.
Uniquely among retirement plans, an ESOP can be leveraged. In one scenario, the plan borrows money from a financial institution or from another party. The plan 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, this includes all full-time workers over age 21. Assuming the company’s shares are not publicly traded, annual independent appraisals track the value of the company’s shares. These appraisals determine the value of each participant’s holdings.
Current law calls for gradual vesting of all employer contributions over 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 plan 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.
What’s more, an ESOP 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 plan sponsor. Going forward, ABC makes tax-deductible contributions to the plan, which uses that money to repay the bank loan. With such an arrangement, ABC effectively borrows money through the plan, then deducts the principal and interest payments made on the plan 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% 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, Alice won’t 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.
An ESOP can be expensive
Business owners sponsoring an ESOP 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 an ESOP 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.