Obtaining financing to fund and operate a business in today’s economic climate can be challenging. It may be even tougher for the owner of a closely-held business to find a buyer with sufficient financing to purchase the business. Banks today aren't lending money to finance new business acquisitions like they used to before the credit crisis, so what options does a seller have in today’s market? An employee stock ownership plan (“ESOP”) can help sellers of closely-held businesses finance the sale, transfer ownership to the employees, and most importantly, maintain employee and business continuity.
What is an ESOP?
An ESOP is a qualified retirement plan that is an employee benefit where most of the assets are invested in employer securities. A corporation establishes an ESOP and contributes shares of its stock to a tax-exempt trust and there are two types of ESOPs, leveraged and non-leveraged. A leveraged ESOP has the ability to borrow money from a bank or other sources, including the owner/shareholder, to purchase the stock held in the trust. The stock is used as collateral for the loan and the corporation makes cash contributions to the trust to pay the debt service on the loan. A non-leveraged ESOP does not involve the borrowing of money as the trust uses cash to purchase corporate stock.
Why an ESOP?
An ESOP has many advantages to the corporation, its employees and the selling shareholders of the corporation’s stock.
There are several tremendous federal income tax benefits for an “S” or “C” Corporation that sponsor an ESOP. An “S” Corporation has 100 or fewer shareholders and its taxable income is generally not taxed at the corporate level. This income is passed through to the shareholders and taxed to them at their individual income tax rates. The stock held by an “S” Corporation ESOP is in a tax exempt trust and any income earned on those shares will not be subject to any federal income taxes. If an ESOP owns 100% of an “S” Corporation then neither the corporation nor the ESOP will pay any income taxes. This tax savings may enable the “S” Corporation to pay off its ESOP debt service, fund participant distributions and finance business operations.
A “C” Corporation” may have many shareholders and pays federal income taxes on its business taxable income at the corporate level with a maximum 38% marginal tax rate. A “C” Corporation can generally not deduct dividends paid to its shareholders. However, it can deduct contributions that it makes to a non leveraged ESOP and dividends paid on the ESOP shares if certain conditions are satisfied. The “C” Corporation can also deduct contributions made to a leveraged ESOP, dividends used to repay an ESOP loan and to the ESOP shareholders. Collectively these tax savings can greatly aid the corporation in paying the ESOP debt service, funding participant distributions and financing business operations.
An ESOP is an employee benefit since the corporation will make periodic contributions to the trust for the benefit of the eligible employees. They will receive a share of the allocation of the contributions, which will be used to pay off the debt service on the loan for the corporate stock that was purchased. The value of their accounts will increase for any dividend and interest income and stock appreciation, and decrease for any expenses and stock depreciation. Employees do not pay income taxes on amounts in their accounts until they are distributed from the trust.
Normally the benefits for the employees are richer in an ESOP as compared to those of certain 401(k) or profit sharing plans since all of the contributions are funded by the corporation. This generosity should help minimize employee turnover, which should improve employee continuity and business operations. In addition, employees generally become motivated and more engaged in the business since they are partial owners.
The biggest benefit for the owner/shareholder is the ability to sell a closely-held business to the ESOP to ensure continuity. This is one of the best means to fund the sale of the business when other funding options may not be sufficient. Federal income taxes on any gain on the sale of the shares of stock sold by an owner/shareholder of a “C” Corporation may be deferred if the ESOP acquires more than 30% of the shares in the corporation and certain other conditions are satisfied. The shareholder must reinvest the proceeds into qualifying stocks, bonds, debentures, etc. and when they are eventually sold the gains will be taxed to the shareholder.
When is an ESOP Best?
Some of the key reasons when an ESOP will work best for a corporation is when the:
- Shareholder of a “C” Corporation who is interested in retiring and selling the business and/or deferring the income taxes on the gain from the sale,
- Owner/shareholder of an “S” Corporation cannot or does not want an outside buyer and the employees want to continue operating the business,
- Shareholder of a “C” or “S’ Corporation found a buyer for the business but the buyer cannot obtain traditional bank financing,
- Corporation is growing its business and needs a cash infusion to foster its growth, or
- The shareholder of an “S” Corporation has a mature business and wants to ensure business and employee continuity.
The additional cash flow from the tax savings can be tremendous opportunity for the corporation to pay off the ESOP acquisition debt, pay or increase dividends on the stock, be retained in the corporation to provide needed capital for improvements or to operate its business, or even to buy another company. However, because of the tremendous tax savings there are certain rules requiring broad employee ownership in the ESOP.
How to Get Started
Is an ESOP right for your corporation? Can an ESOP help the shareholder of a “C” Corporation or the owner/shareholder of“S” Corporation finance the sale of its business? The first step for this determination is to conduct a feasibility study. This will provide the shareholder and corporation with the relevant information to make an assessment about whether an ESOP is right based on its circumstances. RubinBrown Benefits Group, LLC can work with corporations and shareholders to conduct a feasibility study and provide you with the relevant information involved with an ESOP. Please contact Wayne Isaacs for further information.
Under U.S. Treasury Department guidelines, we hereby inform you that any tax advice contained in this communication is not intended or written to be used, and cannot be used by you for the purpose of avoiding penalties that may be imposed on you by the Internal Revenue Service, or for the purpose of promoting, marketing or recommending to another party any transaction or matter addressed within this tax advice. Further, RubinBrown LLP imposes no limitation on any recipient of this tax advice on the disclosure of the tax treatment or tax strategies or tax structuring described herein.
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