Keeping a family business within the same family from generation to generation is not always a possibility. Nevertheless, many family business owners want to ensure that the firm and culture they have worked hard to build is preserved well into the future. An Employee Stock Ownership Plan (ESOP) is a way to keep control of a family-owned business within a different type of family—employees who are loyal to the company and make significant contributions to its growth.
The National Center for Employee Ownership estimates that 6,669 ESOP exist in the U.S. as of the most recent data, covering 14.4 million people. Although its primary purpose is typically to provide a market for the shares of a departing owner of a closely-held business, an ESOP can provide many advantages. An ESOP may make sense for your company in any of the following scenarios.
To buy the shares of a departing owner. Whether you are the sole owner of your business or own it jointly with other family members or partners, succession planning is critical to the long-term success of the business. An ESOP can be a viable option for private, family businesses that lack outside buyers or next-generation family members to take over ownership. In this scenario, the business can make tax-deductible cash contributions to the ESOP to purchase the departing owner’s shares, or the ESOP can borrow money to buy the shares.
Since cash contributions are tax-deductible, this can be an attractive strategy for business owners to sell their shares. Additionally, even if you have no departure plans in the near term, ESOPs give owners the option to cash out little by little. Selling a minority interest in your business through an ESOP offers a way to diversify your wealth by allowing you to investing in other assets.
To borrow money at a lower after-tax rate. One of the unique features of an ESOP as an employee benefit plan is its ability to borrow money on a tax-advantaged basis to fund itself. If you choose not to make cash contributions to the plan outright, the ESOP can borrow cash to buy company shares.. Unlike other debt repayments, when the business repays the loan, both principal and interest payments are tax-deductible.
To create an additional benefit for your employees. An ESOP can be mutually beneficial in that it aligns the interests of owners and participating employees. This can be a powerful strategy for attracting and retaining talent as well as motivating your employees to achieve high performance standards.
Like other employee benefit plans, an ESOP offers certain tax advantages. In addition to the tax benefit to the business for making cash contributions to the plan, employee contributions are tax-free, and distributions are taxed at potentially favorable rates. Additionally, an employee’s ESOP account distributions can be rolled over to an individual retirement account or other retirement plan to defer capital gains taxes.
While ESOPs offer several interesting benefits to the owners and employees of family-owned and other closely held businesses, they have their limitations. ESOPs cannot be used in all business structures, and their setup and ongoing maintenance can be costly. Before deciding whether an ESOP is right for your business, do your research, and consider consulting a tax accountant, attorney and wealth advisor on the best way to transition ownership of your business.