ESOP Tax Advantages

How does the value of the company compare when selling to an ESOP vs. another buyer?
An ESOP pays fair market value for the stock of the company, like any financial buyer (for example, as in private equity transactions). A seller could receive less compensation by selling to the ESOP than by selling to a strategic buyer, but the seller should also consider the additional value that the tax savings of an ESOP sale generate. For instance, a sale to an ESOP can increase the after-tax proceeds to the selling shareholder. The company can also take a tax deduction of up to 25% of payroll by making an ESOP contribution each year. Further, selling to an ESOP can eliminate the ongoing tax or S corporation distribution obligations of the company, providing significant tax savings. This is because an ESOP is a qualified benefit plan, which is a non-tax paying entity. Since an S corporation passes through its profits to the shareholders, the percentage of the company that is owned by an ESOP is exempt from income tax.

How are ESOPs valued?
The company is valued every year by an independent, qualified valuation firm selected by the trustee. The valuation is used to assess the company’s annual share price and subsequently the value of each ESOP account for each employee. The company is valued at fair market value, which is the price at which a willing buyer and a willing seller would agree upon. In transactions that include a management incentive plan and warrants, the value of each are typically tied to the annual valuation of the underlying shares.

Does the business owner have to sell all of the company to the ESOP?
An ESOP allows the business owner, or selling shareholder, to decide how much of the business to sell and the timeline for ownership transition. Sometimes, the owner will initially sell a minority interest then complete a second-stage transaction at a later date. The sales timeline is completely at the discretion of the selling shareholder. Often, the benefits of a 100%-owned ESOP are too appealing to forgo. In addition, as noted below, to take advantage of a 1042 tax-free rollover the owner must sell enough shares to meet the 30% ESOP ownership requirement.

What is the difference between a leveraged ESOP and non-leveraged ESOP?
An ESOP can be either non-leveraged or leveraged. In a non-leveraged ESOP, shares or cash (which can later be used to purchase non-ESOP shares from the sellers) are contributed to the ESOP. Once contributed, these shares are then allocated to employees’ accounts based on their salary, tenure or a combination of both. The company receives a tax deduction for the fair market value of the shares or the cash contributed to the plan, subject to limits. An ESOP is the only qualified retirement plan in the United States that can borrow money. This allows for a leveraged ESOP transaction. In a leveraged ESOP, shares of stock are purchased by the ESOP with a note from either the company or the selling shareholders. As the note is repaid, shares are released to the employees’ accounts. The note repayment is tax-deductible, subject to limits. The shares will typically be subject to vesting. When an employee leaves the company, the employee will be paid out in return for his or her shares, either in a lump sum or over several years. In both scenarios, the employee is the beneficial owner of those shares (and thus receives benefits from the shares), whereas the ESOP trust owns the shares and is the sole shareholder. The trustee has a fiduciary duty to protect the retirement benefit of the employees. The trustee does not insert themselves into the day-to-day operation of the business nor do they typically sit on the board of directors. Instead, their role is to ensure any corporate action taken is in the best interest of the employees.

How are ESOPs valued?
The company is valued every year by an independent, qualified valuation firm selected by the trustee. The valuation is used to assess the company’s annual share price and subsequently the value of each ESOP account for each employee. The company is valued at fair market value, which is the price at which a willing buyer and a willing seller would agree upon. In transactions that include a management incentive plan and warrants, the value of each are typically tied to the annual valuation of the underlying shares.

Does the business owner have to sell all of the company to the ESOP?
An ESOP allows the business owner, or selling shareholder, to decide how much of the business to sell and the timeline for ownership transition. Sometimes, the owner will initially sell a minority interest then complete a second-stage transaction at a later date. The sales timeline is completely at the discretion of the selling shareholder. Often, the benefits of a 100%-owned ESOP are too appealing to forgo. In addition, as noted below, to take advantage of a 1042 tax-free rollover the owner must sell enough shares to meet the 30% ESOP ownership requirement.

What is the difference between a leveraged ESOP and non-leveraged ESOP?
An ESOP can be either non-leveraged or leveraged. In a non-leveraged ESOP, shares or cash (which can later be used to purchase non-ESOP shares from the sellers) are contributed to the ESOP. Once contributed, these shares are then allocated to employees’ accounts based on their salary, tenure or a combination of both. The company receives a tax deduction for the fair market value of the shares or the cash contributed to the plan, subject to limits.

An ESOP is the only qualified retirement plan in the United States that can borrow money. This allows for a leveraged ESOP transaction. In a leveraged ESOP, shares of stock are purchased by the ESOP with a note from either the company or the selling shareholders. As the note is repaid, shares are released to the employees’ accounts. The note repayment is tax-deductible, subject to limits. The shares will typically be subject to vesting. When an employee leaves the company, the employee will be paid out in return for his or her shares, either in a lump sum or over several years.

In both scenarios, the employee is the beneficial owner of those shares (and thus receives benefits from the shares), whereas the ESOP trust owns the shares and is the sole shareholder. The trustee has a fiduciary duty to protect the retirement benefit of the employees. The trustee does not insert themselves into the day-to-day operation of the business nor do they typically sit on the board of directors. Instead, their role is to ensure any corporate action taken is in the best interest of the employees.