ESOP Advantages and Disadvantages

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ESOP Advantages and Disadvantages

For most closely held business owners their business is their biggest asset. At some point, all business

owners will consider transferring that ownership in order to diversify their investment or simply to enjoy

the fruits of their labor. When planned and implemented properly, an Employee Stock Ownership Plan

(ESOP) can help business owners achieve these goals without losing control of the business. An ESOP is

an employee retirement plan that allows employees to invest in their employers company. An

Employee Stock Ownership Trust (ESOT) is formed to oversee the administration of the ESOP. In

addition to providing liquidity, an ESOP can and also be a powerful tool for succession and financial

planning. Since it was specifically designed for this purpose, there are several tax advantages that are

not available to other types of retirement plans.

Advantages

Retain Control

An ESOP allows a business owner to sell a portion of his business and still remain in control. Typically, if

the business interest is sold to an outside party, the owner may need to negotiate the percentage of

ownership sold, the terms of employment, salaries, and fringe benefits. In an ESOP, business owners

can sell all or a portion of their interest. The timing is also flexible; the business owner can sell

whenever they are ready to sell.

Deferred Taxes

If the business is a C Corporation, when the ESOP owns 30% or more of the company ownership, gains

on the sale of interest to the ESOP can be deferred if the owner reinvests the sale proceeds in qualified

securities within 12 months from the sale. The owner can defer the gains indefinitely as long as the

funds are invested in qualified securities. When the owner dies, the securities are included in his estate

and his heirs get to step up in the bases of the securities and the deferred gains disappear.

Note: at the time this article was written, there existed an estate tax and a basis step up requirement.

As of January 1, 2010, the estate tax has been repealed. However, most commentators believe that the


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tax will be reinstated, perhaps retroactively.

Tax Exempt Earnings

In the case of an S Corporation, a portion or the entire company earnings is exempt from taxation

depending on the percentage of ownership by the ESOP. An ESOP creates a tax shield and earnings

that are allocable to the ESOP are not taxable. Thus, if the company is owned entirely by an ESOP, the

company earnings will be entirely tax exempt.

Deductible Dividends

In the case of a regular C corporation, dividends made to a leveraged ESOP are deductible if the

dividends are used to repay the ESOP loan. The deductible dividends are limited to the shares that were

purchased with the loan proceeds. This is useful when the maximum contribution (25% of eligible

payroll) is not sufficient to repay the annual payment. The employer is able to contribute more funds to

the ESOP for repayment of the loan.

Dividends are also deductible if it is a cash dividend and if it is actually distributed to the ESOPparticipants. Cash dividends are deductible only with respect to shares that have been allocated to ESOP

participants. Keep in mind that dividends should be distributed to all shareholders in the same class,

and dividends distributed to non-ESOP shares are not deductible. If distributions to non-ESOP

shareholders are not desirable, the non-ESOP shareholders can decline the dividend before it is

declared.

Disadvantages

Before implementing an ESOP, business owners should evaluate possible problems and disadvantages.

Impact on Balance Sheet


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The companys equity is reduced in the case of a leveraged ESOP. If the company borrows money and

lends it to the ESOP to purchase the company stock, the loan is reported as a liability on the companys

balance sheet and a contra equity account reducing its equity is created. Although this may not impact

the companys operation, the reduced net worth may affect the companys ability to obtain contracts or

bonding when net worth is one of the key considerations.

Valuation

An annual valuation is required to establish the stock value for purposes of making contributions and

purchasing stock. In addition, if the shares sold to the ESOP are overvalued, the seller will be subject to

15% penalty tax.

Liquidity

The company will need to monitor its cash reserve for the repurchase obligation to its departing

employees, especially if a majority of the shares are vested, there is an increase in number of retiring

employees, or there is appreciation in the stocks value.

Company Performance

If the company value does not increase, the company stock is less attractive and employees may wish to

invest their retirement funds somewhere else. In the worst case scenario, if the company fails,

employees will lose their retirement funds that are invested in the company. Losses may be severe if the

ESOP investment is not diversified.

Like most everything, an ESOP has its own pros and cons. It takes a substantial amount of planning and

evaluation. Business owners should consider every aspect of the plan and all possible impacts before

adopting an ESOP.

Documents

ESOP Advantages and Disadvantages