F.A.Q
What is an ESOP?
An Employee Stock Ownership Plan (ESOP) is a tax qualified retirement plan authorized and encouraged by federal tax and pension laws. Unlike most retirement plans, ESOPs: • Are required by law to invest primarily in the shares of stock of the sponsoring employer. • Are trusts that hold shares of the business for employees, making them beneficial owners of the company that employs them. • Can provide tax benefits to the company and to the exiting owner(s). • Can borrow money from related parties to finance company projects—including the tax-advantaged purchase of the company’s shares of stock.
Can I use an ESOP as a financing for growth strategy??
Companies have used ESOPs as a way to finance a variety of efforts, including business expansion, management buyout, acquiring a target company, spinning off a division, and taking a company private. In limited circumstances, ESOPs have been used to finance the buy-out of a firm or company division that otherwise would have closed.
What are the tax Benefits of an ESOP to the owner?
Under federal tax law, owners of closely held companies can defer and possibly avoid tax on the gains made when selling stock to an ESOP—when the following conditions are met: 1. The ESOP company is a C corporation at the time of the sale. 2. The ESOP owns at least 30 percent of the company immediately after the sale. (The sale of stock by two or more shareholders counts toward this 30 percent requirement). 3. The sale proceeds are re-invested in U.S. domestic corporation stocks and bonds within a set time period. To qualify, reinvestments must be made within a 15-month window that starts three months before the date of sale and ends 12 months after the date of the sale to the ESOP. This “tax free rollover”—which is included in the federal tax laws to encourage the establishment of ESOPs—can be very attractive to retiring owners and shareholders of closely held companies
Are there tax advantages to the Company?
Yes. S corporations that sponsor an ESOP are eligible for a different tax incentive: The portion of the business owned by the ESOP trust is exempt from federal (and often state) income tax. What is an ESOP? By The ESOP Association The ESOP Association 1200 18th Street N.W. Washington, D.C. 20036 (202) 293-2971 | www.ESOPAssociation.org © All Rights Reserved The ESOP Association, 2018 | 1 If 60 percent of an S corporation is owned by the ESOP, the business would avoid taxes on 60 percent of its income. A 100 percent ESOP-owned S corporation operates essentially free of income tax.
Additionally, companies have used ESOPs as a way to finance a variety of efforts, including business expansion, management buyout, acquiring a target company, spinning off a division, and taking a company private. In limited circumstances, ESOPs have been used to finance the buy-out of a firm or company division that otherwise would have closed.
Additionally, companies have used ESOPs as a way to finance a variety of efforts, including business expansion, management buyout, acquiring a target company, spinning off a division, and taking a company private. In limited circumstances, ESOPs have been used to finance the buy-out of a firm or company division that otherwise would have closed.
Is there an advantage to being an ESOP company?
In addition to the financial and tax incentives, most companies establishing an ESOP have a keen desire to provide an employee ownership incentive and benefit. In fact, for some companies, the ownership and benefit incentive is the primary reason for the ESOP. Research has shown that giving workers a significant stake in the company that employs them improves employee attitudes toward the company, and these improved attitudes translate into improvement of the company’s bottom line. Companies may well find the added productivity resulting from employee ownership in the company makes the ESOP the best choice.
What is a leveraged ESOP and how does it work?
In a leveraged ESOP, the ESOP or its corporate sponsor borrows money from a bank or other qualified lender, and uses the loan proceeds to buy shares from current owners or the company. If the ESOP is the borrower, the company guarantees the loan. As part of the guarantee, the company agrees that it will make contributions to the ESOP that will enable the ESOP to pay back the loan on schedule. If the borrower is the company—which is the arrangement preferred by many lenders—the company lends the funds from the loan to the ESOP so the ESOP can buy the shares.
If the leveraging is meant to provide new capital for company expansion or improvements, the ESOP will use the cash to buy newly issued shares of stock from the company. If the leveraging is used to buy shares of stock from a shareholder, the ESOP generally will acquire those existing shares directly. If the leveraging is being used to divest a division of the company, the ESOP will buy the shares of a newly created shell company, which in turn will purchase the division and its assets.
Two tax incentives make leveraged ESOP financing very attractive. First, contributions to an ESOP are tax deductible so that: • The company makes contributions to its ESOP. • The ESOP in turn pays those contribution dollars back to the company to pay down its loan from the company. • The company then uses those contribution dollars to pay down its loan from the bank or other lender. In effect, the company gets to fully deduct the loan’s principal and interest (not just the interest, as is the case for non-ESOP loans). By reducing the number of post-tax dollars needed to repay the loan principal, a company’s cost of financing can be cut significantly. Second, dividends paid on shares of a C corporation held in an ESOP are tax deductible if they are used in any of the following ways:
• To repay the ESOP loan.
• Passed through to employees.
• Reinvested by employees for more company stock.
This provision of the federal tax law well may increase the amount of cash available to a company, compared to one utilizing conventional financing.
If the leveraging is meant to provide new capital for company expansion or improvements, the ESOP will use the cash to buy newly issued shares of stock from the company. If the leveraging is used to buy shares of stock from a shareholder, the ESOP generally will acquire those existing shares directly. If the leveraging is being used to divest a division of the company, the ESOP will buy the shares of a newly created shell company, which in turn will purchase the division and its assets.
Two tax incentives make leveraged ESOP financing very attractive. First, contributions to an ESOP are tax deductible so that: • The company makes contributions to its ESOP. • The ESOP in turn pays those contribution dollars back to the company to pay down its loan from the company. • The company then uses those contribution dollars to pay down its loan from the bank or other lender. In effect, the company gets to fully deduct the loan’s principal and interest (not just the interest, as is the case for non-ESOP loans). By reducing the number of post-tax dollars needed to repay the loan principal, a company’s cost of financing can be cut significantly. Second, dividends paid on shares of a C corporation held in an ESOP are tax deductible if they are used in any of the following ways:
• To repay the ESOP loan.
• Passed through to employees.
• Reinvested by employees for more company stock.
This provision of the federal tax law well may increase the amount of cash available to a company, compared to one utilizing conventional financing.
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