Many privately owned businesses find it difficult to face the issue of succession. Sale to an outsider provides immediate liquidity, but an immediate loss of control, while sales to key employees, family members or other insiders can allow a gradual transition and preservation of the business. However, seldom do family members or insiders have the cash necessary to provide liquidity to the business owner, and borrowing to finance an insider purchase can be inefficient from a tax standpoint.

For business owners who want more liquidity but still want to preserve some degree of flexibility and control, an employee stock ownership plan (ESOP) can be the answer.

What is an ESOP?

An ESOP is a qualified retirement plan that is designed to own employer stock. Congress granted ESOPs special tax treatment under the Internal Revenue Code to promote employee ownership of business assets. Uniquely among other ERISA plans, ESOPs are allowed to borrow money to purchase employer stock. Once purchased, employer stock is allocated to accounts for individual participants. When they retire, participants can either receive cash or shares which are then sold back to the company or to the ESOP.

What are the benefits of an ESOP to a Business Owner?

Liquidity

An ESOP allows the purchase of stock from an existing shareholder much as an outside buyer would. This purchase can be funded by borrowing from an outside lender (such as a bank) or through seller notes. Unlike a sale to an outside buyer, an ESOP can purchase some but not all of the seller’s shares. In this way, a seller can obtain partial liquidity without giving up control of the company.

Shareholder Tax Benefits

A sale to an ESOP is a sale of shares in the company, which is eligible for lower capitals gains tax rates (for the remainder of 2012, the capital gains rate on the sale of shares to an ESOP is 15%). For a C corporation, a seller may choose to defer paying capital gains taxes indefinitely under a “Section 1042” transaction.

Control

In an ESOP transaction, the selling shareholder frequently continues to be active in the business and may maintain effective control of business operations, if desired. Family members and key employees also can continue to be involved in the business and may receive incentives so that they benefit from increases in the value of the company.

Flexibility

Unlike a sale to an outside buyer, an ESOP transaction gives a business owner flexibility. The ESOP may buy all of the company shares, or just a part, and the complete transaction may stretch over several years. A sale can be structured to include a transfer of some ownership to family members, charitable trusts and/or key employees. Transactions often include the use of warrants and other devices which may allow the selling shareholder the chance to participate in the future growth of the business.

What are the other benefits of an ESOP?

Company Tax Benefits

When an ESOP borrows money to purchase shares, the loan is repaid through tax-deductible contributions to the ESOP by the company. In effect, this means that both principal and interest payments on the loan are a tax-deductible expense. Further, if the company is an S corporation, income on shares held by the ESOP will not be subject to federal corporate tax, as the ESOP trust is a tax-exempt entity. Thus, an S corporation which is 100% owned by an ESOP is completely exempt from corporate income tax.

Benefits to Employees

The benefits to selling shareholder and the company may be reason enough to establish an ESOP. But employees of an ESOP company also benefit. They annually receive an allocation of shares in the company based on their compensation. Over time, employees become vested in a ownership stake, and the ESOP can be a way for average employees to build capital and wealth. Numerous studies have shown that ESOP companies are more stable, pay greater compensation and provide better benefits than non-ESOP companies. Management of an ESOP company may participate in share ownership through the ESOP, and may also receive incentives in the form of additional share ownership or phantom stock.

What are the disadvantages to an ESOP?

ESOPs can be expensive to implement (but usually no more expensive than other significant corporate transactions.) ESOPs are subject to a number of complicated rules under the Internal Revenue Code and ERISA, so it is important to have advisors who know and understand ESOP transactions. Not every business is suitable for an ESOP, so it is important to have competent advisors run a feasibility analysis on the ESOP transaction before committing.

But in the right situation, a sale to an ESOP can provide benefits to a business owner, the company and employees that are not available with any other type of transaction.