As a business owner, you’re constantly balancing competing objectives. In addition to serving your customers and growing profits, you need to attract and retain talented employees who can help you advance your mission. And depending on your retirement objectives, you may also be planning your exit strategy. The good news is there’s a solution that can help you achieve multiple business goals concurrently. In this article, we’re sharing five ways an employee stock ownership plan (ESOP) can benefit you and your business.
What is an ESOP?
An employee stock ownership plan (ESOP) is an employee benefit plan similar to a profit-sharing program. To fund an ESOP, a business may set up a trust and contribute new shares of its company stock or cash to buy existing shares. Alternatively, an ESOP can borrow funds to buy company stock. The business then contributes cash to the ESOP so it can repay the loan.
The National Center for Employee Ownership (NCEO) estimates there are currently about 6,600 employee stock ownership plans covering more than 14 million participants in the United States. Nearly all ESOPs are company-funded, meaning the employee participants pay nothing.
Indeed, ESOPs aren’t right for everyone. However, understanding the potential advantages can help you determine if an ESOP can benefit your business.
Here are 5 ways an ESOP can benefit your business:
ESOP Benefit #1: Provides an Exit Path
Owners of closely held businesses often have difficulty finding a buyer for their shares. An ESOP is commonly used to solve this problem since it provides sellers with a ready market and increased flexibility.
Even if you have no plans to exit your business in the near term, an ESOP gives you the option to cash out over time. This feature creates an additional benefit, enabling you to unwind a concentrated stock position and diversify your assets.
ESOP Benefit #2: Employee Buy-In
An ESOP is intended to be mutually beneficial for business owners and participating employees. By aligning the interests of all participants, ESOPs can be a useful tool for motivating key employees to achieve high performance standards.
Plus, it can be a powerful strategy for attracting and retaining talented workers. Participants can receive meaningful retirement benefits at no financial cost to them. Moreover, research shows that businesses with ESOPs tend to have lower employee turnover.
ESOP Benefit #3: Potentially Improved Performance
According to one study from Rutgers University—the largest and most significant study to date on the topic—businesses tend to see their performance metrics improve after adding an ESOP. Specifically, results indicate that ESOPs increase sales, employment, and sales per employee by about 2.3% to 2.4% per year. In addition, businesses that add an ESOP are more likely to still be in business several years later. And these businesses are also more likely to offer their employees other retirement benefits.
ESOP Benefit #4: Unique Tax Advantages
ESOPs offer a variety of potential tax benefits for your business. For example, cash and stock contributions to an ESOP are tax-deductible. If you choose not to make contributions outright, the plan can borrow cash to buy new shares or the shares of existing owners. When you repay the loan, both principal and interest are tax-deductible.
In addition, an ESOP gives sellers of C-corporations the opportunity to defer capital gains taxes. Once the ESOP owns 30% of all outstanding shares, you can reinvest your sale proceeds in other securities and defer any tax on the gain. For S-corporations, on the other hand, the portion of ownership held by an ESOP isn’t subject to federal income tax (and in most cases, state income tax).
Lastly, dividends are tax-deductible, and employees pay no tax on contributions to an ESOP. Distributions from an ESOP are taxed, but at potentially favorable rates. Alternatively, employees can roll distributions into a qualified retirement account to defer capital gains taxes.
ESOP Benefit #5: Continuity of Control
If you own a closely held business, you know that transferring the family business to the next generation isn’t always an option. Still, many families wish to preserve the legacy they’ve worked hard to create—even after relinquishing ownership.
An ESOP is a way to maintain control of your business while transferring ownership to key employees. It allows you to reward employees for their loyalty and contributions while ensuring your business’s values and culture remain in place.
Is an ESOP Right for Your Business?
Though the potential benefits are attractive, ESOPs are not without limitations and drawbacks. For example, not all business structures can use ESOPs. Not to mention, they can be costly. In addition to set-up and ongoing administrative expenses, private companies must repurchase shares of departing employees. And any time you issue new shares, they dilute the shares of existing owners.
Before deciding if an ESOP is right for your business, be sure to do your research and consider all options. You may also want to consult your accountant, attorney, or financial advisor to determine if an ESOP can benefit your business—especially if you’re planning your exit strategy.
Oak Capital Advisors has expertise in helping business owners plan their exit strategy and prepare for retirement. If you’d like to discuss your potential exit paths and a plan for your financial future, please get started by requesting your complimentary retirement readiness assessment.
