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The method chosen to transfer ownership of a business for sale is one of the most important factors to consider as a business owner. And the reason for its importance is related to the wide differences in the amount of cash received (net of taxes) by the business owner across the various methods of transfer or sale.
An ESOP or Employee Stock Ownership Plan is one method of ownership transfer or sale business owners consider when they decide it’s time to retire. That said, let’s explore the ESOP as a potential method of transfer or sale from both the business owner’s and employees’ perspectives.
How Does an ESOP Work?
When a company wants to set up an ESOP, it establishes a trust fund. The company then contributes new shares of stock or cash to buy existing shares. The shares are divided among employee accounts within the trust. Vesting schedules vary between individual plans, but employees must receive vested benefits on either a cliff vesting schedule, which is 100% vested after 3 years or less, or on a graded vesting schedule, which provides 20% vesting every year after the second year of employment.
Employers pay ESOP distributions when employees leave the company. The employee is given the stock they have accrued, and the company must buy back the shares at a fair market value if there is no public market for them.
How Does an ESOP Get Funded?
There are three main ways ESOPs get funded.
1. The business can put new shares directly into the ESOP trust fund.
2. The business can put cash into the fund to buy existing shares.
3. The ESOP can be used to borrow money to buy the business’ stock shares.
All company contributions to the fund are tax-deductible.
Is an ESOP a Qualified Retirement Plan?
ESOPs are qualified retirement plans, meaning they satisfy requirements laid out in Internal Revenue Code Section 401(a).
Despite this, employees should not depend on an ESOP as the sole method of financing their retirement.
For instance, if the company stock fails to increase in value or decreases, the employee’s benefit remains flat or loses value.
If the company closes completely, the employee will lose their benefits entirely.
And while varied investment options exist after an employee has participated in the ESOP for 10 years and has reached 55 years of age, ESOPs can lack essential diversification.
The ESOP vs 401K Plan
Both ESOPs and 401(k) plans are retirement accounts offered by employers.
With a 401(k), the employer’s contributions are tax-deferred, meaning that the money is taken out of each paycheck before taxes, and those wages are not taxed until withdrawal.
Whereas with an ESOP, employees also do not pay taxes on the shares in their account until distribution.
In both situations, employers may offer matching contributions.
How is an ESOP Beneficial to a Business Owner?
ESOPs are beneficial to business owners in several ways.
1. The owner can sell part or all of their shares to their employees, while still retaining control of the business operations.
2. Establishing the ESOP trust also ensures there is a market for the owner’s shares.
3. Transfers to an ESOP allow the business owner to defer or bypass capital gains taxes.
4. ESOPs come with even more tax benefits:
a. contributions of stock and cash are both tax-deductible.
b. when the ESOP is used to borrow money, both the loan repayments and interest are also tax-deductible.
5. Allowing employees to own part of the company can also result in increased loyalty and productivity, as they have the ability to impact the value of the stock directly.
How an ESOP may be Beneficial to Employees
If the company has done well, an ESOP account may have performed better than typical investments in an index fund.
Contributions to the ESOP are also permitted to grow tax-free until the distributions are paid. When employees receive their ESOP distributions, they have the option to roll them over into an IRA or other retirement plan and avoid paying taxes until the money is withdrawn for retirement.