Seal your exit strategy with an ESOP

If you own a successful business, chances are a substantial portion of your net worth is tied up in it. Even if you plan to stay actively involved in the company for many years, it’s important to have an exit strategy that addresses when to convert your business interest into cash so you can use it to diversify your investments.

Designing an exit strategy that meets your objectives can be challenging, especially if your business is closely held or the company’s stock is thinly traded. How do you cash out without selling the business to an outsider or giving up control? One solution to consider is an Employee Stock Ownership Plan (ESOP). In addition to creating a market for your stock, an ESOP offers extraordinary tax savings and other benefits to your company and its owners and employees.

Plotting your exit route

An ESOP is a qualified retirement plan, similar to a profit sharing or 401(k) plan. The main difference between an ESOP and these other types of retirement plans is that, instead of investing in a variety of stocks, bonds and mutual funds, an ESOP invests primarily in the employer’s own stock.

Here’s how it works. Often using borrowed funds, the employer makes tax-deductible contributions to the ESOP, which the plan uses to acquire stock from the company or its owners. Essentially, by establishing an ESOP, you create a buyer for your shares. At the same time, you provide a powerful incentive for employees, who now have an opportunity to share in the company’s growth on a tax-deferred basis. When employees retire or otherwise qualify for distributions from the plan, they can receive benefits in the form of stock or cash.

Like other qualified plans, ESOPs are strictly regulated. They must cover all full-time employees who meet certain age and service requirements, and they’re subject to annual contribution limits (generally 25% of covered compensation), among other conditions.

ESOPs are also subject to rules that don’t apply to other types of plans. For example, an ESOP must obtain an independent appraisal of the company’s stock when the plan is established and at least annually thereafter. Also, participants who receive distributions in stock must be given the right to sell their shares back to the company for fair market value. This requirement creates a substantial “repurchase liability” that the company must prepare for.

Leveraging the tax benefits

An ESOP provides a company and its owners with several tax benefits. If the ESOP acquires at least 30% of a closely held C corporation, the selling owners can defer their gain indefinitely by reinvesting the proceeds in qualified replacement property within one year after the sale — an advantage over an outright sale. Qualified replacement property includes most securities issued by domestic operating companies.

ESOPs are unique among qualified retirement plans because they permit a company to finance the buyout with borrowed funds. A “leveraged” ESOP essentially permits the company to deduct the interest and the principal on loans used to make ESOP contributions — a tax benefit that can do wonders for a company’s cash flow. If the company is a C corporation, it can also deduct certain dividends paid on ESOP shares. Interest and dividend payments don’t count against contribution limits.

S corporations with multiple shareholders are now permitted to have ESOPs, but limited tax incentives make them less effective as an exit strategy. Gain deferral and dividend deductions are unavailable, and interest payments on leveraged ESOP loans apply toward the contribution limit.

Staying in control

Another advantage of ESOPs over sales or other exit strategies is that they allow you to cash out without giving up control over the business. Even if you transfer a controlling interest in a closely held company to an ESOP, most day-to-day decisions will be made by the plan’s trustee, who can be an officer of the company.

However, ESOP participants may have the right to vote their shares on certain major decisions, such as a merger, dissolution or sale of substantially all of the company’s assets.

Determining whether an ESOP is right for you

Of course, ESOPs do have some disadvantages: Annual appraisals, repurchase obligations and other requirements make them expensive to administer, and investing in the company’s stock involves some risk. But for owners looking to cash out in a tax-advantaged manner while providing benefits to the company and its employees, an ESOP is definitely a strategy to consider. •