Skip to content

Taking Advantage of the Tax-Efficient Exit Strategy ESOPs Offer

Aug 22, 2022

When you own a closely held company and start approaching retirement age, it’s easy to struggle with balancing conflicting goals for your business. An employee stock ownership plan (ESOP) may be the best answer in a case like this.

Take a Closer Look

It’s common for business owners to tap at least a small portion of the value of their company to fund their retirement. It may also be their wish to preserve their company for their employees, their children, and the community in which they reside.

Transferring ownership as early as possible to the next generation of business owners can have considerable tax advantages. However, it can also further complicate matters. Not all owners are ready to walk away from the company they built, even if it may seem the best decision from a tax perspective.

Consider This Solution

When an owner is not quite ready to walk away from their business, this is where an ESOP can become beneficial to business owners. This type of plan gives business owners a tax-efficient exit strategy and allows them to remain in control until they retire. It is important to note that ESOPs are only available to corporations. For any business organized as a partnership, sole proprietorship, or limited liability company (LLC) to take advantage of this strategy, they would need to convert to a corporate form—a proposition with potential consequences.

An ESOP is a type of qualified retirement plan designed to invest predominately in your company’s stock instead of publicly traded stocks, bonds, or mutual funds. Like other qualified plans, an ESOP is still subject to its own rules and restrictions, like coverage requirements and limits on how much you can contribute. However, they must obtain annual independent appraisals of their stocks, which differentiates them from other plans.

When an employee becomes eligible for benefits, they will typically receive a vested part of their ESOP account balance in the form of either stock or cash. If your business is closely held, any employees who receive stock must be given the right to sell their stock back to the company at fair market value during a specified time, otherwise known as a “put option.”

Calculate the Potential Benefits

The advantages of an ESOP for the owners of a closely-held company are remarkable. When you consider selling some of your company stock to an ESOP, you have a greater chance of achieving higher liquidity, financial security, and diversification of your assets. Furthermore, suppose your company is a C corporation and the ESOP acquires 30% of its stock by reinvesting the proceeds in certain qualified securities. In that case, you can defer taxable capital gains.

Not to worry, giving up ownership to an ESOP does not necessarily mean giving up control—at least not immediately. You have the option to continue serving as the company’s CEO, as a trustee of the ESOP trust, and continue voting on most corporate decisions.

From the estate planning perspective, an ESOP also makes great sense for a company owner. By selling shares to your company’s plan, you are provided with liquid assets that are distributable to other family members that may not be directly involved in the business.

Simultaneously, you can still hold enough stock to transfer control of your business to chosen individuals who are involved.

Business Gains

When the value of the ESOP ties to the company’s stock, employees are given a strong incentive to work hard for the success of the future of the business. Did you know that company contributions to the ESOP that are used to acquire stock are tax-deductible? In turn, the company can even borrow the funds it needs, which essentially allows it to deduct both principal payments and interest on the loan.

When a company is structured as an S corporation, the allocable share of income from the ESOP is exempt from federal income taxes. (Most states have a similar exemption). So, S corporations that are entirely owned by an ESOP can often avoid both federal and state income taxes altogether. Therefore, it is essential to keep in mind that S corporation ESOPs also come with their own tax disadvantages, such as preventing owners from deferring gains on shares sold to the ESOP.

Cost Consideration

While a range of benefits exists, the costs of an ESOP can add up. These costs include the expense of annual appraisals, stock repurchase obligations, qualified plan administration, and loan payments. Therefore, weighing these costs with your advisor before embracing this particular strategy is important. Tax reform may also potentially affect ESOP and specific estate planning strategies, so it’s imperative that you consult your CRI tax advisor before making any critical decisions.

Relevant insights

Join Our Conversation

Subscribe to our e-communications to receive the latest accounting and advisory news and updates impacting you and your business.

By proceeding, you are agreeing to the terms and conditions in the Carr, Riggs and Ingram LLC Privacy Policy.

This field is for validation purposes and should be left unchanged.