Every small business owner will eventually need to think about a succession pla n if they don't try to sell their company outright. This week, a bi-partisan supported bill was introduced in the Senate to encourage one option -- giving your employees partial ownership in your business over time with what's called e mployee stock ownership plans (ESOPs). The bill specifically intends to remove the barriers for S Corporations to establish ESOPs as well as provides S Corps with similar tax incentives to those offered to C Corporations. Small-business owners who are heavily invested in their companies may want to consider this option.
What exactly is an ESOP?
Think of a 401(k) plan, except the funds employees are awarded are invested directly into a trust that acquires shares from the small-business owner over time. The employees will essentially be earning shares from their boss. Of course, there's more to it. The company generally benefits by making a tax-deductible contribution to the trust and the small-business owner can sell stock at a lower capital gains tax rate, as opposed to being subject to the higher ordinary income tax rate levied on profit withdrawals.
Should you set up an ESOP?
This really depends on the company size, small-business owner and employees. For very small companies, setting up and maintaining an ESOP could be a very daunting task. The cost alone to hire ESOP specialists, valuation experts and attorneys can offset many of the benefits in the early years. There's also the big risk for valuation mistakes and the company not performing as well as another retirement account. On the other hand, an ESOP should be strongly considered for companies that have a long track record of success and high employee retention rates.
What are the benefits of the plan?
It provides for a clear and tax friendly way for a small-business owner to realize the value they've created in their company. They also have the option to defer tax liability from the sale to later years by investing the proceeds in replacement property via a Section 1042 transaction. The other benefit, and in some cases the most important one for the small-business owner, is that it provides incentives for their employees to stay with the company and keep it going years after the owner retires.
What are the drawbacks?
In theory, the ESOP makes a lot of sense to the small-business owner and their employees because of its succession incentive. But it's not all peaches and cream. Many small businesses are private companies that need to rely heavily on outside third parties to value the stock at various periods for marking to market the shares. It's extremely difficult and costly to do this and it can be very hurtful to the employees should the shares they purchase be overvalued.
ESOP critics also question whether it is in employees' best interest to tie their entire retirement to the company's success. This is a valid point as it's important to have a fair amount of diversification in your retirement account and you wouldn't want to put all your eggs in one basket. If you're actively building other retirement accounts such as IRAs or Roth IRAs, that's a different story.
What does the Obama Administration think about ESOPs?
There is also the risk of regulatory changes in the future. It's possible that this administration will work to eliminate many of the incentives for creating an ESOP plan as they've hinted with their latest proposal.
If you happened to review President Obama's 2014 budget proposal, you would notice that ESOP provision IRC Section 404(k) was eliminated from the budget. By removing this section, the Obama administration is discouraging ESOP creation and operation as it specifically relates to large C Corporations. As mentioned previously, one of the benefits in ESOPs is that it allows companies to deduct the value of dividends paid on ESOP stock passed through to employees. This was never a benefit for S Corporations and other entities, so one can position that Obama is trying to penalize larger companies.
In the end, you'll need to weigh the pluses and minuses for an ESOP plan as it specifically relates to your company and goals. Don't be afraid to ask your employees what they think about the plan.