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The ESOP Plan Advisors The ESOP Plan Advisors The ESOP Plan Advisors 1 ESOP strategies to diversify your business and preserve your legacy We have been asked many tax considerations in their Our goal is simple: to help you times why we specialize in companies while helping to grow more than wealth. An ESOPs. The answer is simple— resolve matters of wealth ESOP can be an effective tool we believe in small and middle transfer and business to help you achieve this goal. market businesses. It is so succession. satisfying to watch a person grow an excellent idea, product Listed U.S. company count is down 46% from peak or solution into something Domestic companies listed on U.S. exchanges, thousands they can be proud of and turn Source: https://ca.finance. into a legacy. yahoo.com/news/jp- startup-public-companies- fewer-000000709.html Business owners often use Listed U.S. company count employee stock ownership is down 46% from peak. plans (ESOPs) to address (Image: JP Morgan liquidity, diversification and Asset Management) Investment and insurance products offered through RBC Wealth Management are not insured by the FDIC or any other federal government agency, are not deposits or other obligations of, or guaranteed by, a bank or any bank affiliate, and are subject to investment risks, including possible loss of the principal amount invested. 2 RBC Wealth Management What is an ESOP? An employee stock ownership plan (ESOP) is a qualified retirement plan that provides tax advantages to both the employer and employees. Similar to a traditional profit sharing plan, an ESOP offers many additional advantages. Benefits for the employer Benefits for the employee ESOPs provide a unique way for A unique aspect of ESOPs is that business owners to diversify their risk benefits are paid to participating on a tax-advantaged basis. They allow employees in the form of company business owners to cash out some or stock. A trust fiduciary sets up all of their equity in the company while individual accounts within the trust keeping operational control. Closely for each participating employee. The held business owners can use an ESOP employer then contributes either cash as an excellent estate-planning tool that or shares of company stock to the trust generates liquidity for their shares and on behalf of participating employees. creates succession options for those If employers make cash contributions, involved in the business. the trust uses that money to purchase shares of company stock either from Designed to invest mainly in the stock shareholders or from the company itself. of the employer, an ESOP can be a stock bonus plan or a combination An ESOP is an excellent way to reward stock bonus plan and money purchase employees with retirement benefits at pension plan. The Internal Revenue no cost to them while inspiring them to Code (IRC) gives tax incentives to participate in the growth and success employers who sell their company stock of the company. Because ESOPs have to the ESOP. Companies can benefit many tax advantages, employees do not from tax savings in many ways using this pay tax on the stock allocation to their unique corporate financing strategy. accounts until distributions are taken, usually after retirement. The ESOP Plan Advisors 3 Who qualifies for an ESOP? A growing trend The potential ESOP candidate ESOPs have existed for many years. While each situation is different, here The concept was first developed in the are some characteristics of a possible 1950s and legislation implementing tax ESOP candidate: advantages for ESOPs was passed in • The company must currently be a 1974. From numbering only a handful C corp, or a Sub S, or be willing in the 1970s, today there are more than to convert. 11,000 ESOP plans*. • The company must have sufficient The National Center for Employee collateral or cash flow to support Ownership (NCEO) estimates funded debt. that ESOPs have 13.7 million plan • A successor management team participants and control over $900 should be in place or developed billion in plan assets*. ESOP legislation over time. continues to provide incentives and advantages to both companies and • The company should have been employees, adding to the attractiveness in business for several years and of this liquidity option*. be experiencing steady and controlled growth. Because of the broad appeal of these • The company should have had plans, ESOP candidates can vary widely. strong earnings and cash flow over Most ESOPs (approximately 97 percent) the previous two years and be able are established for privately held to reasonably predict future revenue companies.* Any company—whether a and cash flows (probably more manufacturing, distribution or service important than having hard assets to business—that can borrow enough support the loan). money to fund the ESOP is a viable • The selling shareholders should want candidate. However, high-end service to participate in the future growth of businesses with educated workforces— the company after the sale. such as architecture, engineering or consulting firms—tend to be better represented in ESOPs today. *National Center for Employee Ownership (NCEO). 4 RBC Wealth Management Why business owners choose ESOPs Three key reasons why business owners Exit strategies choose ESOPs as their financing strategy Baby boomers are retiring rapidly these of choice are: 1) tax advantages; 2) exit days and over the next four decades, strategies; and 3) to build company value. approximately 30 to 40 percent of businesses in the U.S. will be changing Tax advantages ownership as a result*. ESOPs offer Currently, the tax code gives sellers the important benefits to help company potential to defer capital gains tax while owners make this transition. These giving the company tax deductions of benefits make ESOPs an excellent the transaction price over time, which alternative to other exit strategies. They can enhance cash flow and improve can facilitate family business succession credit metrics. ESOPs are tax exempt planning and estate planning through and pay no tax on their pro-rata share of the transfer of different types of assets company earnings. In addition, only 30 to family members with different levels percent of the business needs to be sold of involvement. And because ESOPs can to the ESOP to obtain these tax benefits be structured as a series of transactions, and the owner can continue to actively they can be either an intermediate or participate in and receive compensation long-term exit strategy. from the business. Building company value Finally, the tax benefits of an ESOP produce financial rewards not just for ESOPs give sellers the ability to profit the company but also for the owner from building value in the company and the employees. As the employer over many years and to gain liquidity sponsoring an ESOP for your employees, to diversify wealth or buy other assets. your contributions to the plan, whether ESOPs can also be strong motivators in the form of company stock or cash that in services industries by adding to the is used to purchase company stock, are benefits of employees owning stock generally tax deductible on your federal and aligning shareholder interests income return for the year in which you with those who drive shareholder make those contributions. However, to value—employees. ESOPs can also help be eligible for this employer tax benefit, circumvent a poor buyer’s market, help your plan must remain a “qualified” plan. in the transition of franchisee ownership, be structured to take advantage of foreign tax treaty provisions, use other qualified plan investments, facilitate a going-private transaction, and more. *National Center for Employee Ownership (NCEO). The ESOP Plan Advisors 5 How ESOPs work The following steps illustrate the way most companies establish an ESOP: Loan “Mirror” Loan Repayment to ESOP 1. A company borrows money to finance the purchase of stock from current Bank/Lender Company shareholders. Commercial 2. The company then lends these funds Loan to the ESOP. 3. A trust is created to buy stock of the Principal & Interest Contributions company on behalf of the ESOP plan. Loan Repayment 4. The company makes annual cash contributions from its operating profits to the trust (which are tax Cash deductible). Diversifying ESOP Trust 5. The trust uses the cash to pay down Shareholder(s) the ESOP loan while a trust fiduciary Shares releases and allocates shares of the company’s stock to the accounts of plan participants (employees) Company Shares according to a pre-established formula. 6. After time, employees are vested based on years of service for the shares in their account. 7. When employees retire or leave the Employees company, they receive a distribution of their vested benefits in the form of cash or company stock. If in stock, the employee can choose to either hold the stock or sell it back to the company at fair market value. If the stock is not publicly traded, the employee must have the right to sell the stock to the company at fair market value. 6 RBC Wealth Management IRC §1042 IRC §1042 and qualified are called by the issuer, or sold. Thus, a to 90 percent or more of their market replacement property business owner might be able to defer, value. As a result, business owners or possibly eliminate, capital gains on can monetize them by borrowing a A 1042 ESOP Exchange allows a the sale of their business. substantial portion of their market value shareholder to exchange his or her and then reinvesting the borrowed interest in a private company for a Wealth management and ESOPs funds in a diversified portfolio of stocks, portfolio of qualified replacement bonds and other assets. property without paying any capital gains Business owners can generate income taxes on the transaction.
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