The concept of employees owning stock in their employer is not new. In 1974, Congress enacted the Employee Retirement Income Security Act which gave birth to the Employee Stock Ownership Plan ("ESOP"). An ESOP is a defined contribution retirement plan (similar to a profit sharing plan or money purchase plan) qualified as tax-advantaged under the Internal Revenue Code. Unlike other qualified plans, an ESOP must invest primarily in employer securities and may borrow against the employer's credit to cover the acquisition costs. These unique attributes, together with the benefits provided to all qualified plans (i.e., the employer may deduct its contributions subject to certain limitations and the employees pay no taxes until distribution of their benefits), form a powerful tool for use in corporate transactions.
Prior to January 1, 1998, this tool was not available to closely-held businesses that were S corporations, because an S corporation was prohibited from having an ESOP as a shareholder. Effective January 1, 1998, however, the Small Business Jobs Protection Act of 1996 and the Taxpayers Relief Act of 1997 opened the door for S corporations to establish ESOPs. This change presents several important planning opportunities for closely-held corporations that are S corporations and for C corporations that currently have ESOPs.
A traditional and common use of ESOPs has been to fund the cash-out of shareholders of closely-held businesses at retirement. Diversification is crucial for owners of privately held businesses who are nearing retirement age. If the major personal asset is stock in a closely-held business, an ESOP provides a valuable diversification vehicle. The net proceeds from the sale to the ESOP can be invested in publicly-traded securities by way of a tax-free rollover of the sale proceeds. The effect of a properly structured rollover is to defer the tax liability on the sale to the ESOP until the publicly-traded securities are sold.
There may also be tax advantages to the corporation. If the ESOP borrows money to fund the purchase, then the company is able to pay the interest and the ordinarily nondeductible principal on the borrowed funds indirectly, by making fully-deductible contributions to the ESOP. If instead the company were to use borrowed money to purchase the stock directly from the owners in a typical redemption, then only the interest payments would be deductible.
A C corporation that is not interested in utilizing the traditional ESOP tax incentives, or that already has an ESOP in place, may want to consider converting to S status. Since the S corporation itself pays no income tax, if the ESOP owns 100 percent of the company all of the cash earmarked for paying corporate income taxes can be retained by the corporation once the S election is made. This deferral of taxes on the ESOP's share of corporate income enhances the cash flow for the S corporation. The larger the ESOP, the more likely it is that the non-ESOP shareholders may not need a cash distribution to cover their personal income taxes. If the tax liability of non-ESOP shareholders is small, it can be covered with an increase in cash bonuses to these individuals.
A newly formed S corporation may establish an ESOP for employees as part of its employee benefits program. Employees become shareholders of the company and participate directly in the good and bad fortunes of the employer. As an owner, an employee is more likely to be concerned about profitability and productivity. Additionally, the prospect of future sales to the ESOP can provide the shareholders with a mechanism for adding liquidity. If the S corporation is able to accrue additional value due to the deferral of income tax liability, then future stock sales may also be at high values.
As with all qualified retirement plan matters, you should consult with your professional advisors regarding the establishment of an ESOP and the related tax consequences in your specific situation. In general, however, the S corporation-ESOP marriage looks like a promising one.
R. Neal Keesee, Jr.
Mr. Keesee is a Principal in the Firm.
E-mail: keesee@woodsrogers.com
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