An Employee Stock Ownership Plan (ESOP) may provide a solution.  This article summarizes ESOP advantages and disadvantages.  

 

An ESOP is a qualified retirement plan designed to purchase stock from an employer or its stockholders.  As qualified plans, ERISA rules and restrictions regarding minimum participation, coverage and vesting generally apply to ESOPs.  ESOP assets, which may include employer stock, cash, or other investments are allocated to the employees' accounts in proportion to their compensation and held in trust for them.

 

ESOPs acquire employer stock by purchasing it directly from the company or its stockholders.  A company may contribute stock to the ESOP and deduct the value of the stock.  If an ESOP borrows money from a bank or other lender to purchase company stock, it is known as a leveraged ESOP.  The company makes tax-deductible contributions to the ESOP that are sufficient to enable the ESOP to meet its annual loan payments.

 

Distributions are made to employees or their beneficiaries at retirement, termination of employment, disability or death.  Distributions may be made in a lump sum or in installments and in either cash or stock. 

 

If closely held stock is distributed to former employees, they usually cannot sell the stock without first offering it to the company or the ESOP.  Employees usually have the right to sell the stock back to the employer or the ESOP at its fair market value.

 

Business succession planning options for small business owners are often constricted by a lack of liquidity, a limited number of potential buyers, and because a substantial portion of their net worth is tied up in the business. 

 

An ESOP provides a friendly buyer who will allow the owner to retain control of the company.  Contributions to the ESOP by the corporation to pay the acquisition debt are fully deductible; in contrast to a direct purchase by the corporation where only interest is deductible.  Gain on the sale of the business can be deferred if the owner reinvests the proceeds in qualified replacement property.

 

To defer gain the selling stockholder must have owned the stock sold for at least three years and not have received the stock as compensation.  Immediately after the sale, the ESOP must own at least 30% of each class of outstanding stock or 30% of the total value of the outstanding stock of the corporation. 

 

The proceeds from the sale must be reinvested in qualified replacement property within a replacement period that begins three months before the sale and ends 12 months after the sale. 

 

Qualified replacement property generally can be defined as stocks and bonds of United States operating companies.  Government securities and shares in mutual funds do not qualify as replacement property.

 

ESOPs can help small business owners fund their succession plan, acquire cheap liquidity and act as an employee motivational tool.  Although the downside is the expense of creating the plan and the required regulatory compliance, in recent years Congress has expanded the provisions to allow S corporations to use ESOPs.