One way for business owners to transition their ownership to employees and to receive liquidity for their stock shares is through the establishment of an employee stock ownership plan(ESOP).
An ESOP is a type of a tax-qualified retirement plan that is similar to a profit sharing plan, except an ESOP must invest primarily in the common shares of the employer. The plan’s acquisition of an employer’s stock may be financed by borrowing from the ESOP sponsor or from the selling shareholders. ESOPs are commonly used to provide a market for the shares of owners of closely held corporations that are not yet marketable. The industries in which ESOPs are most common include manufacturing, construction, engineering, and wholesale trade. According to the National Center for Employee Ownership there are approximately 7,000 ESOPs operating in the United States.
An ESOP gives owners of closely help corporations an opportunity to develop a transition plan that allows the business to be sold over a period of time that is convenient for them and provides an alternative to a sudden exit strategy and an excellent transition option for business owners with a long term dedicated workforce. An ESOP can motivate and reward employees of the business by creating ownership opportunities and retirement assets.
Business owners can realize both tax and non-tax benefits from using an ESOP to exit their business. Shareholders of a C-Corporation who sell at least 30% of their stock to an ESOP can defer taxes on the capital gains from the sale of shares. In S-Corporations, the percentage held by the ESOP is not subject to federal income tax. Additionally, contributions made by the corporation to repay the ESOP loan are tax deductible , which means financing can be accomplished with before tax dollars.
ESOPs can also provide an important non-tax benefit as owners may want to reward employees who have made significant contributions to success of their company. When such employees become owners, they often feel an increased sense of connection with the company. A 2014 Employee Ownership Foundation research study found that the establishment of an ESOP increased employee productivity, increased revenue, and profitability.
ESOPs are one of several exit strategies that business owners should be aware of when considering transitioning their business.