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Weighing the ESOP option
1 Oct, 2008 By: Mark Battersby Landscape ManagementAn Employee Stock Ownership Plan (ESOP) can be established and funded in a variety of ways. Usually the business borrows funds that are loaned to the ESOP. The ESOP uses the funds to buy out the selling owner(s). Following the purchase, the business makes annual, tax-deductible contributions to the ESOP, which the ESOP uses to pay down the debt.
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There are benefits all around. For the incorporated business, all contributions to the ESOP are deductible, which means it is buying out the owner using pre-tax dollars. But naturally, there also are possible downsides to ESOPs (see "Potential cons").
An ESOP's inner workings
With an ESOP, the business establishes a trust fund, into which it contributes shares of its own stock or cash to buy existing shares. As an alternative, the ESOP can borrow money to buy new or existing shares, with the business making cash contributions to the plan to help it repay the loan.
Allocations generally are made on the basis of relative pay. As an employee's length of service increases, he (or she) acquires an increasing right to the shares in his account, a process known as "vesting." Employees must be 100% vested within six years, depending upon whether vesting is all at once or gradual.
When employees leave the business, they receive their account balance, which might be company stock — which the business must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual independent appraisal to determine the price of their shares.
Benefiting from an ESOP
As the owners of many Green Industry businesses approach retirement age, they increasingly face the dilemma of how to cash out. Fortunately, ESOPs do not always mean relinquishing control of their operations.
Employees must, of course, be allowed to vote their allocated shares on major issues — such as a merger or consolidation, a liquidation or sale of a substantial amount of the business assets. It is the business, however, that decides whether to pass through voting rights on other issues. In publicly held businesses, employees must be able to vote on all issues.
Multi-function ESOPs
There are many reasons, each unique to a specific situation, for creating an ESOP. An owner of a privately held business can, for example, use an ESOP to create a ready market for his shares. Because almost all of the value of his stock in the business represents capital gain, the selling owner also can reap the benefits.
Under this approach, the business can make tax-deductible cash contributions to the ESOP to buy out an owner's shares, or it can have the ESOP borrow money to buy the shares. In a regular corporation, once the ESOP owns 30% of all the shares in the business, the seller can reinvest the proceeds of the sale in other securities and defer tax on the gain.
When the owner sells to an ESOP and reinvests the proceeds within a 15-month window, the gain on the sale is deferred until the newly purchased securities are sold. If the owner dies before selling those securities, the capital gains might escape taxation altogether.
ESOPs also are useful helping businesses borrow money at a lower after-tax cost. ESOPs are unique among benefit plans in their ability to borrow money. The ESOP borrows cash, which is used to buy company shares or shares of the existing owner(s). The business then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are tax-deductible.
One of the biggest benefits can be the non-taxability of S-corporation earnings, to the extent that the ESOP holds shares of a S-corporation.
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