How ESOPs Benefit Owners, Companies, and Employees in Succession Planning

Why an ESOP is a viable choice for ownership succession

Succession planning can be one of the toughest decisions a business owner will ever face. After years, sometimes decades, of pouring time, energy, and resources into building a company, many owners struggle with how to step away while ensuring the business continues in capable hands. For those who also want to reward the employees who helped build that success, the question becomes even more complex: How do you retire, secure your legacy, and take care of your team?

One strategy that has gained popularity over the years that addresses all three of these concerns is the Employee Stock Ownership Plan (ESOP). An ESOP is a retirement benefit plan for employees that invest primarily in the stock of the employer’s company. By creating an ESOP trust, a company can purchase shares from the business owner. Over time, the employees earn ownership in the company through allocation of shares – typically based on compensation or years of service.

An ESOP is more than just an employee benefit. It can serve as a powerful tax and succession planning tool that benefits the company, the selling owners, and the employees.

How does an ESOP benefit everyone?

Benefits for the company:

• Tax deductible contributions: Contributions of stock or cash to the ESOP are deductible under IRS §404(a).
• Deductible loan repayments: If the ESOP uses a loan to purchase the company stock, the contributions to repay both the principal and interest are deductible, subject to limits. Typically, principal payments on a loan are not tax-deductible.
• Corporate tax savings: In an S Corporation business structure, the portion of earnings attributable to ESOP owner shares is not subject to federal income tax. A 100% ESOP owned S Corporation would not be subject to any federal income tax.
• Company retains its identity/culture after sale: Unlike selling to private equity or a competitor, an ESOP allows the company to maintain its culture, legacy, and independence while transferring ownership.

Benefits for the owners/selling shareholders:

• Capital gain deferral (C Corporations): Under IRC §1042, owners of closely held C Corporations can potentially defer or eliminate the capital gains taxation on the sale of stock. If at least 30% of the stock is sold to an ESOP, the selling owner/shareholder can reinvest the proceeds in qualified replacement property and defer recognition of the gain. This allows the seller to diversify their wealth while also minimizing capital gains tax.
• Maintain role in company: Owners/shareholders can keep a seat on the ESOP’s board to remain active in management post-ESOP transactions.
• Flexible sale options: Owners/shareholders can sell the stock to the company at one time or in phases which allow flexibility on succession/estate planning.

Benefits for the employees:

• Ownership in company: Employees gain a beneficial ownership interest in the business without having to invest their own money. Research shows that ESOP companies experience voluntary quit rates 5 to 3 times lower than non-ESOP companies, highlighting their impact on retention.
• Retirement savings without requiring contributions: According to the National Center for Employee Ownership (NCEO), the average ESOP participant has 5 times more retirement assets than the average U.S. worker in a non-ESOP company. Employees build this wealth without any out-of-pocket contributions.
• Tax deferred growth: Employees do not recognize income when ESOP contributes their shares in the company. The value grows-tax deferred similar to other qualified retirement plans.

Employee Stock Ownership Plans (ESOPs) are complex, but for the right business, they offer a unique combination of tax efficiency, succession planning flexibility, and employee engagement.

At Keiter, our team can help evaluate whether an ESOP is the right tool for your succession goals. Contact your Keiter Opportunity Advisor| Email | Call: 804.747.0000 to start the conversation.

Sources:

• National Center for Employee Ownership
• ESOP