Employee Stock Ownership Plans (ESOPs) can offer lucrative tax benefits for your business – as well as contribute to a smart exit strategy
Watching your business grow is rewarding, but it can also be daunting when higher revenue leads to a bigger tax bite from Uncle Sam. Understanding how taxes impact your business and your long-term goals will help you evolve from ad hoc tax compliance to a carefully considered tax strategy that can drive the success of your company.
In this installment of our series on long-term tax strategies, we explore how Employee Stock Ownership Plans (ESOPs) can help proactive owners reap tax benefits as their businesses expand into new lifecycles. ESOPs emerged relatively unscathed from the new Tax Cuts and Jobs Act of 2017, and an experienced certified public accountant can help you incorporate them into a thoughtful, long-term tax plan – one that evolves as your business does.
What is an ESOP?
It usually goes something like this: A majority partner wants to retire, but the remaining partners can’t afford to buy him or her out – or maybe they also are ready to enjoy their golden years. Employees get their resumés together as rumors abound that the company will be sold to a competitor. Other interested parties – important customers, suppliers, lenders – start to ask pointed questions about the owners’ succession plan.
More and more owners are turning to ESOPs as a solution. Created by the Employee Retirement Income Security Act of 1974, ESOPs have evolved into a powerful exit planning option for business owners – with major tax benefits.
An ESOP is a tax-qualified defined contribution employee benefits program that primarily invests in the stock of the company that sponsors the plan. Put simply, it’s a tax-exempt trust that gives employees a chance to reap rewards from an increase in the value of their company.
ESOPs are “qualified” because the sponsoring company, the selling shareholder, and any participants receive various tax benefits. They are almost always a contribution to the employee and not an employee purchase.
ESOPs are most commonly used to provide a market for the shares of departing owners of successful, closely-held companies. They are also a strategic way to motivate and reward employees and can be used to enhance the viability of growth transactions by making debt repayments fully deductible. They are different from most benefit plans in their ability to borrow money.
The National Center for Employee Ownership estimates that more than 6,600 ESOPs currently exist, covering 14 million people.
Biggest tax benefits
- Stock contributions are tax-deductible. Companies can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP. Just be sure to think this action through carefully: It dilutes existing owners.
- Ditto for cash contributions. A company can contribute cash to an ESOP on a discretionary basis and claim a tax deduction for it, whether the contribution is used to buy shares from current owners or build a cash reserve for future use.
- Contributions used to repay a loan by ESOP – used to buy company shares – are tax-deductible. The plan can borrow money to purchase new, current, or treasury shares. No matter the use, raising or changing the balance of equity is done in pretax dollars.
- Pre-tax dollars can be used to support acquisitions and expansions. Instead of repaying loans or equity investments that were part of a growth strategy with after-tax dollars, a company can sell stock to the ESOP on terms that mirror the required payments. Within applicable limits, this effectively lets the company making the payments with pre-tax dollars.
- Along those lines …Reasonable dividends used to repay an ESOP loan – passed through to employees or reinvested by employees in company stock – are tax-deductible.
- Sellers in a C corporation are eligible for a tax deferral. Once an ESOP owns 30 percent of all the shares in a C corporation, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain.
- In S corporations, the percentage of ownership held by the ESOP is not subject to federal income tax (and often state tax). If an ESOP holds 20 percent of the stock, there is no tax on 20 percent of the profits.
- Employees pay no tax on contributions to the ESOP– only the distribution of their accounts, which are generally done at more favorable rates. Employees can roll over their distributions in an IRA or other retirement plans – or pay current tax on the distribution – with any gains accumulated over time taxed as capital gains.
A few caveats
- The 2017 tax bill states that net interest deductions for businesses are capped at 30 percent of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years. From that point onward, the cap lowers to 30 percent of EBIT.
Companies that leverage their ESOPs to borrow an amount that is large relative to their EBITDA could find that their deductible expenses become lower – while their taxable income becomes higher.
- ESOPs can’t be used in partnerships and most professional service corporations.
- Private companies must repurchase shares of departing employees, which can become a major expense.
- ESOPs can be expensive to set up; a qualified CPA can help you weigh the costs against the tax, employee motivation, and exit plan benefits they provide.
ESOPs can serve as a lucrative option for companies searching for tax strategies that can grow with their company. They are not, however, for everyone, and an experienced CPA can help determine if they are the right strategy for your business. When properly structured, ESOPs can be valuable assets that contribute to a company’s competitiveness and long-term success.
Of course, ESOPs are not the only long-term strategy that can offer lucrative tax benefits to your company. Watch for additional installments of our series, where we show how captive insurance programs can be a wise choice for certain businesses.
Provident CPA & Business Advisors serves successful professionals, entrepreneurs, and investors who want to get more out of their business and work less, so they can make a positive impact in their lives and communities. Typically, our clients reduce their taxes by 20 percent or more and create tax-free wealth for life. Contact us for expert advice on long-term tax strategies, and to find out how we can help your business exceed your expectations.