Employee Stock Ownership Plans (ESOPs) and S-corporations – a Perfect Match?
Employee Stock Ownership Plans (“ESOPs”) are a means of attracting and retaining employees, growing your business, and providing for the future succession of your company. At its basic level, ESOPs use financial incentives that allow a company to grow while maintaining a control structure more typical of a family-owned business. According to a Rutgers study, ESOP companies grew between 2.3% to 2.4% faster than their non-ESOP counterparts. ESOP companies have higher productivity, employee retention, and job security. Although ESOPs can be complex to form and operate, their benefits can easily outweigh the burdens; especially when an ESOP is a shareholder in an S-corporation.
What is an Employee Stock Ownership Plan (ESOP)?
The ESOP was created under the Employee Retirement Income Security Act (“ERISA”). Like 401(k), IRA, and profit-sharing plans, they are all “defined qualified-contribution retirements plans.” The plans allow sponsors and participants to receive special tax treatment. The employer’s contributions are deductible and the employee has a growing tax-free retirement account – until distribution. Of course, all this is within a network of Internal Revenue Codes (“IRC”), ERISA, and other federal regulations.
An ESOP, however, is decidedly different from the traditional 401(k). The ESOP is a tax-exempt trust that is wholly funded by the company. The trust buys new or issued stock and holds it for the benefit of the employee until retirement or another qualified reason to withdraw. Then, the participants receive either their stock or a cash buyout. Thus, the employees are indirect owners of the company.
Operating Your S-Corporation Tax-Free
The greatest advantage of an S-corporation ESOP is its ability to defer taxes. To understand this, it’s important to comprehend an S-corporation’s tax structure.
Unlike a traditional C corporation, an S-corporation is a “pass-through” tax entity. Meaning, there is no income tax paid at the corporate level – the individual pays it. Formerly, ESOPs were not relevant to an S-corporation because a trust, like the ESOP, could not be a shareholder. However, this changed in the 1990s, when Congress passed legislation allowing an ESOP trust to become a shareholder of an S-corporation. As a consequence, the tax-exempt trust pays no federal income tax proportional to its ownership in the company. Thus, a 100% ESOP-owned company pays no federal income tax (and usually no state income tax). In reality, this is really a tax-deferral because participants will eventually pay taxes at distribution. But what the long deferral period does is gives a company time to accumulate large cash reserves for reinvestment, acquisitions, paying off debts, and otherwise growing faster than their non-ESOP competitors.
The Leveraged ESOP and Creating a Buyer for Your Company
The second advantage unique to ESOPs are they can be leveraged unlike other contribution plans. So, a departing owner can avoid the trouble of finding a buyer, which is especially relevant in a volatile market or when trying to sell a unique business. In addition, an ESOP may take out a loan for other legitimate business purposes, like expansions and acquisitions.
The most common method to leverage an ESOP involves two loans. Because of restrictions, the lender typically prefers an “external loan” to the company. The company loans the ESOP an “internal loan” to purchase stock. Then, the company uses pre-tax dollars to contribute to the ESOP to pay off the loan. Contributions to the ESOP are tax-deductible up to 25% of the eligible payroll.
Getting Quality Employees
Although the tax-related benefits are the most conspicuous, the positive employment atmosphere created with ESOPs is an added bonus. Evidence has shown that combining an ESOP with other strategies of employment participation yields demonstrable results. Everything from employee overall satisfaction, company growth, and productivity occurs when employees feel a personal stake in their company. It’s recommended that the company form an ESOP committee and take other steps to publicize and inform the employees about the ESOP structure. Simply setting up the ESOP structure without addition ways of facilitating employee involvement wastes a huge opportunity.
The IRC, ERISA, the Department of Labor, and numerous federal regulations make sure that ESOPs are heavily scrutinized. In the early 2000s, ESOPs were being abused as a method of avoiding taxes and benefiting a privileged few within a company. More regulations were put in place that have largely addressed these schemes. However, ESOPs require a team of specialists to comply with laws and administrative regulations, including vesting rights and minimum employee coverage.
Sometimes a C-corporation ESOP is preferable to an S-corporation ESOP for capital gains and dividends purposes. Again, like the entire ESOP process, this involves weighting the pros and cons. Transitioning comes with its own regulations and tax consequences.
Companies Partially Owned by ESOPs
S-corporations give out “distributions” to shareholders, usually to pay taxes. They give out a proportional share to the ESOP as a shareholder as well. But these distributions are not tax-deductible. Which means, the less the ESOP owns, the more non-ESOP shareholders take away from the company’s potential cash reserves. This is why 100% ESOP-owned companies are so common and companies between 50% to 99% are so rare. To many businesses, the benefits of diluting ownership are not worth it to 75% are not worth it. In the end, the owners will have to decide what percentage to sell to the ESOP and how quickly they wish to exit the business.
There is a reason that 100% ESOP owned S-corporations continue to be popular. The financial benefits can be ground-breaking, your employees are encouraged by having an ownership stake, and you can retire with their business in good hands. Just make sure you hire the right people to guide you through the process!
*The information in this article is for informational purposes only and should not be construed as legal advice. The information in this article is not privileged and does not create any attorney-client relationship.