Picture this: Instead of selling your business to an individual or a few key employees, you decide you want to sell it to all of your employees—you know, the ones who have helped you get to this point in the first place?
An employee stock ownership plan (ESOP) allows you to do just that. ESOP’s are very popular and more and more clients are looking into them as a potential exit opportunity. There are many technicalities and legalities in forming an ESOP; my goal in this article is not to dissect them, but rather to help you understand the concept of the ESOP in simplest terms so you are equipped to evaluate it as an option for your exit.
What is an ESOP?
At a very high level, an ESOP is a Trust and the Trust is what actually acquires your company. So instead of an individual or an entity buying your business the Trust will acquire the stock/assets of the business. The Trust (buyer) will typically hire a third party Trustee to represent them in the sale negotiations. This Trustee acts just like a typical buyer and often hire third party valuation experts to help determine the Fair Market Value.
An ESOP is similar to a 401(k) in that it must qualify under the Employee Retirement Income Security Act of 1974 (ERISA) standards for employee benefit plans. Instead of monetary profit sharing contribution, the employer offers the employees stock in the company.
An ESOP is somewhat comparable to your own personal trust which holds your personal assets like your house in case you pass away. For purposes of exiting, think of an ESOP as an entity owned by your employees, to which you sell your business in the form of company stock.
Why an ESOP and not Just Directly to the Employees?
There are many significant benefits to selling to an ESOP but most are around the legacy protection when you transfer the wealth to the employees and the second is the tax benefits to you receive. Owners of flow-through entities such as LLCs and S corporations pay company taxes on their personal returns instead of paying corporate taxes—thus the term, “flow-through,” meaning the profit flows through the company to the owner. In contrast, a C corporation pays taxes at the entity level.
Depending upon how you structure the ESOP, the profits made by the Company can becomes tax-deferred because the profit is redistributed to the employees in the ESOP instead of passing directly to the owners. Essentially, the ESOP functions as a tax-protected trust formed under ERISA; again, the employees are the beneficiaries. Instead of selling your business to an owner, you are selling it to a trust that owns all shares of the business. The trust then hires a third-party trustee to oversee distributions to the employees. This benefit allows the payback of the note much faster because the business can use pre-tax profits instead of after-tax.
When a company describes itself as “employee owned,” you are usually looking at an ESOP. According to the National Center for Employee Ownership (NCEO), Florida-based Publix Super Markets is the largest ESOP, with approximately 188,000 employees enrolled.
What Are the Benefits?
ESOPs incentivize business owners to pass wealth to their employees rather than an individual. Aside from the societal benefits of wealth distribution, an ESOP gives employees a reason to invest–literally and figuratively – in the company. By holding stock, they gain wealth as the company becomes more valuable. Employee distributions in an ESOP are tax-deferred, allowing them to have a share of the company’s profit, with no income tax until they decide to sell their stock.
Put simply, an ESOP can be a key piece to developing a winning culture for your company to thrive after your exit. What better way to thank and repay your employees for their hard work than by cutting them a share of profits? That’s not even mentioning the tax advantages for everyone involved.
To learn more about ESOPs and other exit strategies for business owners, contact Exit Consulting Group today. We’re here to help you identify and implement your ideal transition to the next chapter in life.