Financial: ESOP Benefits Far Exceed a Goodbye

By Mark E. Battersby / Published August 2016

 

In addition to being an excellent exit strategy with significant tax savings for the owners, shareholders, and members of pressure cleaning businesses, employee stock ownership plans (or ESOPs) are great for motivating and rewarding employees—and for taking advantage of incentives to borrow money for acquiring new assets in pre-tax dollars.

Almost unknown until 1974, today many businesses are using ESOPs for a variety of purposes other than the succession planning they are most closely associated with. Launching an ESOP isn’t just about benefiting the business owner. Most owners willing to go to the trouble of implementing such a plan have the interests of their employees and the business in mind.

ESOPs 101

Employee ownership in a waterjetting or pressure washing business can be accomplished in a variety of ways.  Employees can buy stock directly, be given it as a bonus, receive stock options, or obtain stock through a profit sharing plan. Some employees become owners through worker cooperatives where everyone has an equal vote. But by far the most common form of employee ownership in the U.S. is the ESOP, or employee stock ownership plan. 

An ESOP is a qualified retirement program in which employees receive shares of the business rather than stock. ESOPs are said to be “qualified” because they qualify for federal income tax deferral until the stock is turned into cash at retirement.

An ESOP offers employers two advantages. First, the business gets significant tax breaks. It can, for instance, borrow funds through the ESOP for expansion or other purposes, deducting both the repayment and interest when the loan is repaid. 

With ordinary loans, only interest payments are tax deductible.  In addition, the owner of a pressure cleaning business who sells his or her stock to the ESOP can defer or often even avoid capital-gains taxes associated with the sale of the business. With these essentials, ESOPs have become an important tool in succession planning for business owners preparing for retirement.

In addition to being an important succession planning tool for contractors, manufacturers, and distributors thinking about retirement, employees also benefit from an ESOP. When it comes to the employees of the pressure cleaning business, ESOPs are in most respects similar to 401(k) plans except that, instead of cash, the business providing the ESOP “pays in” its own stock. But, as in 401(k) plans, all full-time employees meeting certain age and service requirements must be eligible. However, unlike a 401(k) plan, employer contributions to an ESOP do not become the property of the employee until after specified vesting periods are satisfied.

Under both an ESOP and a 401(k) program, employees receive monetary benefits on retirement or in the event of death or disability. The chief difference is that with a 401(k) the funds paid in are invested in a diversified portfolio; in the ESOP, they hold only the company’s own stock. The advantages and risks of ESOPs derive from this difference.

ESOPs provide incorporated water jetting businesses and their employees the tax benefits of a qualified plan, and an excellent financing vehicle for generating capital through their ability to borrow to acquire employer securities.

Buying and Selling A Business

An ESOP can also be a useful tool when it comes to buying and selling the pressure cleaning business. In fact, an ESOP is often an excellent tool for selling a minority interest in the business. By selling a portion of his business, an owner can invest in other assets, providing much-needed wealth diversification. 

A business owner nearing retirement age can sell his or her stake in the business to the ESOP in order to gain tax advantages and provide for the continuation of the business. According to many experts, transferring ownership to the operation’s employees in this manner is preferable to a sale to a third-party.

After all, third-party sales have negative tax implications if successful.  Buyers may be difficult to find; and after the transaction, collecting installment payments may turn out to be difficult or costly. With an ESOP, more certain results are possible. 

The ESOP can borrow money to buy out the owner’s stake in the business. If, after the stock purchase, the ESOP holds more than 30 percent of the business’s shares, the owner can defer capital-gains taxes by investing the proceeds in a Qualified Replacement Property (QRP). QRPs can include stocks, bonds, and certain retirement accounts. The income stream generated by the QRP can help provide the business owner with income during retirement.

ESOPs can also prove helpful to those interested in buying a small business. Many individuals and businesses have raised the capital to finance such a purchase by selling non-voting stock in the business to its employees.  This strategy allows the purchaser to retain the voting shares in order to maintain control of the business.

Major Tax Benefits

ESOPs have a number of significant tax benefits, including these major considerations:

Contributions of stock are tax-deductible. That means a pressure cleaning business can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP, although this means existing owners’ shares will be diluted.

Cash contributions are deductible. The business can contribute cash on a discretionary basis year-to-year and take a tax deduction for it, whether the contribution is used to buy shares from current owners or to build up a cash reserve in the ESOP for future use.

Contributions used to repay a loan the ESOP takes out to buy shares in the business are tax-deductible. The ESOP can borrow money to buy existing shares, new shares, or treasury shares. Regardless of the use, the contributions are deductible, meaning ESOP financing is done in pre-tax dollars.

Sellers in a regular C corporation get a tax deferral. With an incorporated business, once the ESOP owns 30 percent of all the shares in the business, the seller can reinvest the proceeds of the sale in other securities, deferring any tax on the gain.

In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually the state level as well). That means there is usually no income tax on 30 percent of the profits of an S corporation with an ESOP holding 30 percent of the stock, and no income tax at all on the profits of an S corporation wholly owned by its ESOP. However, the ESOP still must get a pro-rata share of any distributions the pressure cleaning business makes to owners.

Dividends are tax-deductible. Reasonable dividends used to repay an ESOP loan, passed through to employees, or reinvested by employees in the business’s stock are tax-deductible.

Employees pay no tax on the contributions to the ESOP, only the distribution of their accounts, and then at potentially favorable rates. The employees can roll over their distributions into an IRA or other retirement plan or pay current tax on the distribution, with any gains accumulated over time taxed as capital gains. The income tax portion of the distributions is, however, subject to a 10 percent penalty if made before normal retirement age.

Not too surprisingly, all contribution limits are subject to certain limitations, although these rarely pose a problem for a well-advised water- jetting business—or its owner, shareholders, or members.

Beware the ESOP

As attractive as these tax benefits are, however, there are limits and drawbacks. The tax laws do not allow ESOPs to be used in partnerships or most professional corporations. ESOPs can, of course, be used in S corporations, but they do not qualify for the unique rollover treatment accorded those ESOPs using regular corporation entities and have lower contribution limits.

Privately-held pressure cleaning businesses are, for instance, required to repurchase the shares of departing employees, and this can become a major expense. The cost of setting up an ESOP is also substantial—as much as $40,000 for a simple, basic plan for a small business, quickly rising based on the size of the business and number of employees involved. 

And remember, any time new shares in the business are issued, the value of stock owned by existing owners is diluted. That dilution must be weighed against the tax and motivation benefits an ESOP can provide.  Finally, ESOPs will improve corporate performance only if combined with opportunities for employees to participate in decisions affecting their work.

Reportedly, only about two-thirds of ESOPs are used to provide a market for the shares of a departing owner of a profitable, closely-held business. Most of the remainder are used either as a supplemental employee benefit plan or as a means to borrow money in a tax-favored manner. Less than three percent of ESOP plans are in public companies.

That’s right—whether used as a supplemental employee benefit plan or as a means to borrow money in a tax-favored manner, ESOPs are more than a tool for retiring small pressure cleaning business owners or a path to easing their way out of the business.