By: Saul Jimenez & Pawel Szeliski, CPA
Stock Ownership Can be Strong Recruiting and Retention Tool
As Baby Boomers continue to retire and transition ownership in their companies either to family members or outside buyers, another type of transaction is emerging as an option – an employee stock ownership plan, or ESOP.
An ESOP is a good option for a seller who doesn’t have family members interested in owning the company and who doesn’t want to sell to an outside buyer such as a private equity or venture capital entity.
While ESOP formation has remained flat for the past five years, research shows that interest in ESOPs rises as business owners become more educated about their benefits. Moreover, today’s high interest rates may drive more interest in ESOP formation as valuations are discounted, making sales of companies to external buyers less attractive.
What is an ESOP?
An ESOP is an employee benefit plan that gives workers ownership interest in the company in the form of shares of stock.
When a business owner decides to utilize an ESOP for business succession, the first step is creation of a trust that holds the assets of the ESOP. The trust obtains bank financing to buy the company from the owner, then pays the debt service on the financing over several years.
As the financing debt is paid down, shares in the company are transferred to the trust and apportioned to each employee based on compensation. Periodic allocations of shares enable employees to build equity in the company over time.
Various tax benefits exist for companies that sponsor ESOPs. For instance, if a C Corporation sells a portion of the company to an ESOP and observes certain rules governing investments, any gain to the owner that is realized is tax free.
Although ESOPs provide retirement benefits to participants, companies usually also have a 401(k) plan running alongside. The contributions to the ESOP for each employee are made by the company, not the individual. So, individual retirement contributions are made separately by employees to their 401(k) plans.
The Pros
One significant advantage to ESOPs is the ability to align the company’s interests with those of the employees. In other words, when employees have skin in the game as owners, they think more like owners and take a more active, insightful role in the operations, knowing they will reap the financial benefits down the road.
There are also tax advantages for companies and for the selling owners. Sales to ESOPS generally are stock sales, giving the owner capital gain treatment for the transaction. Moreover, an S Corporation that is 100% owned by an ESOP pays no income taxes, and a C Corporation can effectively deduct the loan payments made on the ESOP bank financing.
ESOPs also can be advantageous in the Human Resources area. In this age of tight labor markets, an ESOP can serve as a strong incentive for new talent to join a company and for existing talent to stay.
Audit Requirement
There are challenges to setting up an ESOP, however. The costs of maintaining an ESOP are sometimes daunting to smaller businesses, contributing to the significant drop-off of companies under 50 employees that have ESOP plans. Depending on the size of your company, setup and first-year operation of an ESOP can cost anywhere from $80,000 to $250,000. Expenses include fees for legal and accounting services, as well as consulting services. Annual costs thereafter may be $20,000 to $30,000, including the cost of an annual audit, which is a legal requirement.
The ESOP operating entity will need an annual audited financial statement prepared for the bank that holds the ESOP’s loan and for the valuation company.
An ESOP plan audit is conducted as a full-scope audit. During an ESOP audit, the auditor will review the plan’s documentation to ensure that it meets legal requirements and that the plan’s assets are properly valued. The auditor will also examine the company’s financial statements to ensure that the ESOP’s financial transactions are properly recorded and that any related tax implications are appropriately accounted for.
The auditor will review the company’s procedures for administering the ESOP, including the methods used to allocate shares to employees and the methods used to determine the value of the company’s stock. The auditor may also review the plan’s communications to employees to ensure that they are clear and accurate.
The goal of an ESOP audit is to provide assurance to the company, plan participants, and regulatory authorities that the plan is being managed in compliance with applicable laws and regulations, and that the interests of plan participants are being protected.
Another oddity of ESOP finance is the reality of negative equity. Negative equity is a deficit of owners’ equity occurring when the book value of an asset used to secure a loan is less than the outstanding balance on the loan. However, as the ESOP pays down its loan, the shareholder equity equalizes and eventually enters positive territory.
Is an ESOP Right for You?
If you are looking to transition your company’s ownership in the next three to five years, and you’d like to discuss the option of an ESOP, contact your KRD advisor.
