Question: I am a business owner and, by spending more time with my family during the pandemic, I have decided to retire in the next few years. I’ve heard of an ESOP option, but what are the benefits and risks?
A: Congratulations on thinking about the next steps in your succession plan and preparing early. The Employee Share Ownership Plan (ESOP) is becoming more and more popular this year, and currently more than 10 million Americans work for companies owned by their employees.
Under an ESOP, participating employees take a share of company ownership through a retirement savings scheme. Meanwhile, the business and its existing owners can benefit from some tax breaks, an extra-motivated workforce, and, potentially, an effective succession plan.
Learn more about an ESOP:
- How does an ESOP work? To implement an ESOP, you set up a trust fund and either contribute shares or money to buy the shares (a “non-leveraged” ESOP) or by borrowing funds to buy the shares initially and then contributing. in cash to the plan to allow it to repay the loan (a “leveraged” ESOP). Trust shares are allocated to individual employee accounts, often using a formula based on their respective compensation. The business must formally adopt the plan and submit the plan documents to the IRS, along with some other forms.
- What is the tax impact? There are a few, but one of the most important benefits of an ESOP is that contributions to qualified pension plans such as ESOPs are generally tax deductible for employers. However, employer contributions to all defined contribution plans, including ESOPs, are generally limited to 25% of covered payroll. But C companies with leveraged ESOPs can deduct contributions used to pay interest on loans. That is, interest is not counted towards the 25% limit.
Dividends paid on ESOP shares passed on to employees or used to repay an ESOP loan may be tax deductible for C corporations, provided they are reasonable. Dividends voluntarily reinvested by employees in company stock in the ESOP are also generally deductible by the company. (However, employees should consider the tax implications of dividends individually.)
President Joe Biden’s proposed $ 6 trillion budget includes a potential 17% increase in the top capital gains tax rate. Shareholders of some private C companies can sell shares to ESOP and defer federal income tax on the gains from the sale, with several stipulations. One is that the ESOP must own at least 30% of the shares of the company immediately after the sale. In addition, sellers must reinvest the proceeds (or an equivalent amount) in qualified replacement real estate securities of national operating companies within a specified time frame.
Finally, when a business owner is ready to retire or leave the business, the business can make tax-deductible contributions to the ESOP to buy back the shares of the outgoing owner or apply to the ESOP. to borrow money to buy the shares.
- Are there any risks? The tax impact of an ESOP for types of entities other than C corporations differs somewhat from what we have discussed here. And while an ESOP offers many potential benefits, it also comes with risks such as complexity of setup and administration, and in some situations, strain on cash flow.
Speak with professionals experienced in ESOPs. ESOPs can be great options for businesses facing an impending ownership transition. They can offer various tax benefits, while enabling an effective succession plan that also motivates employees and boosts performance. But they can be complicated, and they aren’t for everyone. Contact your accounting and financial advisors to find out if an ESOP would be right for your business, and if so, consider enlisting their implementation assistance.
Crystal Faulkner is a Cincinnati Market Leader with MCM CPAs & Advisors, a CPA and Consulting Firm providing expert advice and beyond thinking for today’s public and private businesses large and small. , non-profit organizations, government entities and individuals. Tom Cooney works at Wealth Dimensions, an investment advisory firm. For more information, call 513-768-6796 or visit online at mcmcpa.com. You can listen to Tom and Crystal daily on WMKV and WLHS on “BusinessWise,” a morning and afternoon radio show that features successful people, businesses, organizations and issues from across our region.