by Joseph E. Marx

When owners of closely-held businesses face the decision of planning a succession strategy, their options may include going public, gifting to family members, selling to a competitor or selling to employees and management. Often the most attractive option is selling to employees and management. However, management generally does not have the capital to purchase the business. An ESOP (Employee Stock Ownership Plan) provides the capital vehicle for management and the employees. Through the use of an ESOP, an owner can:

• Sell all or a portion of their stock and defer or permanently avoid paying taxes on the gain,
• Retain control of the company, (if desired), and
• Reduce or even eliminate future corporate taxes.

An ESOP is a qualified retirement plan where the company makes contributions on behalf of employees that grow tax-free until termination or retirement, when the employee receives his or her vested interest in the plan. But an ESOP is also much more than a retirement plan. An ESOP is designed to be invested in employer securities, so the ESOP becomes part of the corporation's capital structure.

An ESOP can borrow money and use it to buy some or all of the owner's stock. The selling owner may be eligible to defer (possibly indefinitely) the gain on the sale of stock for income tax purposes. Contributions to the ESOP to pay down the debt generally are tax deductible. In addition, if the company is an S corporation, earnings passed through to the ESOP are not subject to current income taxes. In short, the ESOP provides a very efficient means to finance the transition of a business, by using the tax savings to pay for the shares. This will enhance the corporation's cash flow and the value of the business. Employees and shareholders will benefit from the tax savings and increased cash flow opportunities.

Making the S Election. The key benefit in adopting an ESOP for an S corporation is the ESOP does not have to pay tax on its share of the S corporation earnings. C corporations with existing ESOPs or considering adopting ESOPs now have the option to elect S corporation status as part of their overall tax planning. An important advantage of the S corporation is that rather than being taxed once at the corporate level and again at the shareholder level, shareholders of S corporations are taxed only once on their share of S corporation's earnings.

Better still, an ESOP does not have to pay tax on its share of the S corporation's earnings. Instead, tax is applied to distributions to the participants.

For 100% ESOP companies, the choice is easy. They can eliminate a current layer of taxes. For others, the benefits of C status may still outweigh the benefits of S status. Many of the benefits to C corporations with ESOPs, such as higher contribution limits and deductions for certain dividends, are not available to S corporations. Moreover, the main benefit available to the seller of stock to an ESOP, tax deferral upon the sale, is not available to sellers of S corporation stock. However, the tax savings from a single layer of tax, the basis build-up and estate planning opportunities for S corporation shareholders are tremendous incentives.

The key to evaluating an ESOP strategy versus alternative strategies is to evaluate each thoroughly.

Business Transition Strategy

Consider the following advantages of utilizing an ESOP:

• Cash flow better under ESOP transaction (tax savings are paid to company to repay loan)
• Employee retirement benefit provided through stock
• Net income enhanced due to growth from reinvesting cash savings
• Remaining shareholders benefit from growth in company
• After loan is repaid, tax savings can be used to fund repurchase liability

Liquidity for the Shareholder

An ESOP can be a great tool to provide an owner of a closely-held business with liquidity. An owner can use an ESOP to obtain financing to diversify investments or use some of the value of the company for personal uses.

Finance Corporate Growth or Acquisition

Rather than stripping the cash out of the company, many owners are using an ESOP to finance growth and expansion. In many cases, an owner can sell 10% or more of the company to the ESOP and use the cash flow benefit to finance growth. In most cases, the value of the portion of the business retained by the owner will be worth more than if the owner did not sell any stock to the ESOP.

Too Good to Be True? The key to determining whether an ESOP is appropriate for a particular situation is to analyze the full financial impact. An ESOP transaction can be designed in many different ways to best meet the company's, seller's, shareholders', and employees' goals. The unique book, cash and tax effects of an ESOP should be compared to alternative transactions to verify an ESOP is appropriate and to maximize its value. To enter into a transaction without a clear understanding of these financial effects would be risky.

Ernst & Young's approach is unique. We combine our deep knowledge of tax, accounting and benefit plans with the experience from hundreds of ESOP transactions to determine the design and strategy that works best for your corporation.

Joseph E. Marx is a national leader in Ernst & Young's ESOP Services Group. He has been with the firm for more than 18 years specializing in tax, employee benefits and ESOPs. His experience includes extensive financial analysis, transaction and plan design, managing the implementation process and employee communication. He can be reach via e-mail at joseph.marx@ey.com.

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© Copyright 2007 Center for Simplified Strategic Planning