Is An ESOP The Right Way For You To Transition Ownership?

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In 1961, Jim Braas began selling products out of the trunk of his car. Today, the 110-employee Braas Company is one of the leading distributors of industrial automation products and services, working with over 80 suppliers. In 1986, Jim decided the best way to start business transition was an Employee Stock Ownership Plan (ESOP), a kind of retirement trust that can buy and hold company stock. The plan borrowed money to buy some of his shares in 1986 and ultimately took out another loan to buy all the shares in 2012.

Janis Negretti-Samuel, Braas’ Director of Human Resources, said that the plan has resulted in “deeper interest in everyone in the general overall operations and success of the company, helping us come out of recession in better shape than its competitors.” The company trains all its employees to be “CEOs” (certified employee owners) and gives them a business card identifying them as a CEO. There is an annual CEO training process that teaches people about the ESOP and the business plus, regular employee meetings to discuss state of the company. Twice a year, meetings are held to update employees on all aspects of the business.

S. G. Morris, a Cleveland-based a distributor of industrial, mobile, and automation equipment started its employee ownership plan even earlier. In the 1960’s, selected employees were allowed to use bonuses to buy company stock. In 1982, the founder changed that plan so that annual cash contributions were made to an ESOP to use to buy shares over time. By 1999, the ESOP had acquired all 100 percent of the shares. Kevin Martin, S.G. Morris president, said the ESOP had been a great tool for the company and its 70 employees, helping to attract and retain the best people.

Braas and S.G. Morris are just two of many industrial distributors who have used an ESOP for business transition. As baby boomers reach the age where they want to get liquidity for their ownership of their companies, interest in ESOPs has increased. Congress has intentionally made ESOPs the most tax-favored way possible to provide for business transition, as explained below. But ESOPs are not just about taxes. ESOPs can own any percentage of the company and can buy shares all at once or in stages. They allow sellers to get out all at once or gradually while retaining whatever role in the company they choose. Many baby boomers find they want to stay on in some capacity with the company even after they sell. ESOPs, as opposed to sales to third parties, make that possible. Finally, many business owners are not just looking to maximize how much they can sell the company for but also to leave a lasting legacy for their employees and the community, something ESOPs can help make possible. Finally, as Braas and S. G. Morris have found, if companies go beyond simply sharing ownership to also sharing information about company performance and involving employees in day-to-day decisions about how their job is done, they will normally easily outperform competitors.

ESOPs are not for every company, however. This article looks at how they work and whether they make sense for you.

What is an ESOP?

An ESOP is a kind of employee benefit plan, similar in many ways to qualified retirement plans and governed by the same law (the Employee Retirement Income Security Act). ESOPs are funded by the employer, not the employees. Stock is held in a trust for employees meeting minimum service requirements and allocated to employees based on relative pay or a more level formula, then distributed after the employee terminates. ESOPs cannot be used to share ownership just with select employees, nor can allocations be made on a discretionary basis.

ESOPs have a variety of tax benefits:

  • For the owner of a C corporation, proceeds on the gain from the sale to the ESOP can be tax-deferred by reinvesting in the securities of other domestic companies. If these securities are not sold prior to the owner's death, no capital gains tax is ever due. If the company is an S corporation, LLC, or partnership, it can convert to a C corporation before the sale to take advantage of this tax deferral.
  • ESOPs are funded not by employees but by tax-deductible contributions from the company to the plan to buy shares. This kind of corporate stock redemption is not normally deductible. So if an owner sells $5 million in share through a corporate redemption, the company normally must make about $8 million in pre-tax money to leave $5 million for the purchase. An ESOP sale only requires $5 million.
  • Employees are not taxed on the contributions until they take a distribution after they leave the company, and then are taxed as in any other retirement plan.
  • In S corporations, the percentage of profits attributable to the ESOP’s ownership is not taxable. A 30 percent ESOP pays no tax on 30 percent of the profits; a 100 percent ESOP pays no tax.

The plan is governed by a trustee who votes the shares, but the board appoints the trustee, so changes in corporate control are usually nominal unless the plan is set up by the company to give employees more input at this level. Companies can pass through full voting rights if they want, however.

Financing an ESOP

The simplest way to use an ESOP to transfer ownership is to have the company make tax-deductible cash contributions to the ESOP trust, which the trust then uses to gradually purchase the owner's shares, as was the case at S.G. Morris. Alternatively, as at Braas, the owner can have the ESOP borrow the funds needed to buy the shares. In this way, larger amounts of stock can be purchased all at once, up to 100 percent of the equity. Loans can come from banks or, as is increasingly the case, from sellers taking back a note at a reasonable rate of interest (currently about 5 percent to 9 percent).

The price the ESOP will pay for the shares must be determined at least annually by an outside, independent appraiser. Generally, all full-time employees who have worked for a year or more must eligible to be in the plan. Allocations in the plan are based on relative pay or a more equal formula. Distributions are made after termination on a flexible basis, with the employees putting the shares back to the company or being bought out before they leave.

ESOPs are not for everyone. Companies generally need to have at least 15-20 employees to justify the costs of setting up and maintain the plan and must have qualified successor management. An ESOP can pay what a financial buyer would pay, but not what a synergistic buyer, such as a competitor, might offer. Companies also need to be profitable enough to buy the shares. For companies that do meet the basic criteria, however, an ESOP is well worth considering.

Corey Rosen is the founder of the National Center for Employee Ownership, a nonprofit information and membership organization (www.nceo.org).

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