ESOPs are growing in popularity these days as a way of transitioning ownership of a private company to its employees. The owners can sell any portion of the business in a series of transactions over time. ESOPs can serve as an effective financing tool and save business owners and the company quite a bit in taxes.
The idea behind the ESOP is to enable non-owner employees to acquire ownership in the company they work for. The ESOP plan is tax qualified to provide investment in company stock. As such an ESOP is subject to the Employee Retirement Income Security (ERISA) Act in the US.
The sponsoring company may contribute funds to the ESOP. The plan can use the money to buy stock from current shareholders. Alternatively, the company may decide to issue additional shares that are put into the ESOP. The advantage of this approach is that the fair market value of the stock handed to the plan is tax deductible. The ESOP allocates the shares in a way similar to other pension and profit sharing plans.
ESOP may also borrow money from creditors and transact deals with third parties to buy company stock in a way that would otherwise be prohibited under the ERISA and IRS revenue code.
The company can also put together a leveraged ESOP using borrowed funds to buy stock from the current company owners. The money to buy the shares is borrowed from a creditor, such as a bank, pledging the company assets as collateral. Again due to the tax deductible nature of ESOPs, both the principal and interest on the loan are repaid with pretax money.
Using other people’s money to fund some or all of company stock for an ESOP leverages company assets and is known as leveraged buyout. More and more small businesses opt for doing this especially when the interest rates are low and banks are willing to make such loans.
This tax advantaged way to buy newly issued company stock makes ESOPs an attractive financing vehicle. The company can raise equity financing without the need to pay out cash to company’s shareholders.
ESOPs are popular because they offer a number of financial advantages to the shareholders, the company and its employees.
The selling shareholders enjoy attractive tax benefits under the Internal Revenue Code Section 1042. In fact, a shareholder can defer the capital gains from stock sale indefinitely as long as:
- The stock has been held for at least three years prior to its sale.
- ESOP acquires at least 30% of the outstanding stock following the sale.
- The sale proceeds are invested in a qualified replacement property, usually stock of a domestic firm.
Dividends paid out to ESOP members are deducted from the company’s taxable income. The same deduction rule applies to the dividends used to make the loan repayments of a leveraged buyout ESOP.
It comes as no surprise that businesses giving employees a chance at owning part of the company tend to create better motivated workforce. Employees can see how their work translates into growing company value and increase in their personal financial worth. They gradually become the owners of the company they work for.
ESOPs are quite versatile and can help the company meet a number of important goals:
- Provide a good retirement package to employees.
- Serve as a mechanism behind the management buyout.
- Sell an operating unit of the company to its staff.
- Raise additional capital using tax deductible contributions as the source.
If you think setting up a proper ESOP calls for business valuation, you are right. But this discussion is for another post.