ESOPs can help business owners with succession planning
December 6, 2024
Devising and executing the right succession plan is challenging for most business owners. In worst-case scenarios, succession planning is left to chance until the last minute. Chaos, or at least much confusion and uncertainty, often follows.
The most foolproof way to make succession planning easier is to give yourself plenty of time to develop a plan that suits the intricacies of your situation and then gradually implement it. One vehicle that can help “slow your roll” into retirement or whatever your next stage of life may be is an employee stock ownership plan (ESOP).
Little by little
An ESOP is a type of qualified retirement plan that invests solely or mainly in your company’s stock. Because it’s qualified, an ESOP comes with tax advantages as long as you follow the federally enforced rules. These include requirements related to minimum coverage and contribution limits.
Generally, the company sets up an ESOP trust and funds the plan by contributing shares or cash to buy existing shares. Distributions to eligible participants are made in stock or cash. For closely held companies, employees who receive stock have the right to sell it back to the company — exercising “put options” or an “option to sell” — at fair market value during certain time windows.
Although an ESOP involves transferring ownership to employees, it’s different from a management or employee buyout. Unlike a buyout, an ESOP allows owners to cash out and transfer control little by little. During the transfer period, owners’ shares are held in the ESOP trust and voting rights on most issues other than mergers, dissolutions and other major transactions are exercised by the trustees, who may be officers or other company insiders.
Appraisals required
One big difference between ESOPs and other qualified retirement plans, such as 401(k)s, is mandated valuations. The Employee Retirement Income Security Act requires trustees to obtain appraisals by independent valuation professionals to support ESOP transactions. Specifically, an appraisal is needed when the ESOP initially acquires shares from the company’s owners and every year thereafter that the business contributes to the plan.
The fair market value of the sponsoring company’s stock is important because the U.S. Department of Labor specifically prohibits ESOPs from paying more than “adequate consideration” when investing in employer securities. In addition, because employees who receive ESOP shares typically have the right to sell them back to the company at fair market value, the ESOP provides a limited market for its shares.
Drawbacks to consider
An ESOP can play a helpful role in a well-designed succession plan with an appropriately long timeline. However, there are potential drawbacks to consider. You’ll incur costs and considerable responsibilities related to plan administration and compliance. Costs are also associated with annual stock valuations and the need to repurchase stock from employees who exercise put options.
Another potential disadvantage is that ESOPs are available only to corporations of either the C or S variety. Limited liability companies, partnerships and sole proprietorships must convert to one of these two entity types to establish an ESOP. Doing so will raise a variety of tax and financial issues.
In addition, it’s important to explore the potential negative impact of ESOP debt and other expenses on your financial statements and ability to qualify for loans.
Not a no-brainer
ESOPs have become fairly popular among small to midsize businesses. However, the decision to create, launch and administer one is far from a no-brainer. You’ll need to do a deep dive into all the details involved, discuss the concept with your leadership team and get professional advice. Contact us for help evaluating whether an ESOP would be a good fit for your business and succession plan.
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