Question: An employee stock ownership plan can (a) assure a retiring business owner a fair market for the sale of his or her firm; (b) ease the purchase of a business and defer tax on corporate earnings through special provisions in the IRS code; (c) give employees a vested stake in a firm’s future by providing for their retirement security; (d) avail advisors of multiple life insurance sales opportunities; or (e) all of the above.

If you answered (e), you get an “A”. An ESOP, a tax-qualified retirement plan that lets employee-owners accumulate shares of a company as part of their compensation, is fast becoming a favored vehicle among business owners for securing retirement money on tax-advantaged basis and for transitioning control of their firms to key employees or family members, say experts.

That’s good news because, in addition to the advantages they offer sellers and new owner-employees, ESOPs can yield benefits for the economy–even in bad times.

According to a 2010 study conducted by Georgetown University’s McDonough School of Business, Subchapter S-corporations with ESOPs (S-ESOPs), the most prevalent private business entity, enjoyed a 2% rise in employment in 2008 while U.S. private employment fell by nearly 3% over the same time period. These firms grew wages by nearly 6% while U.S. earnings per worker rose only half as much; and they boosted retirement account contributions by more than 18%, compared to 2.8% for all U.S. firms.

The S-ESOP’s impressive track record was a chief selling point underpinning a lobbying effort on Capitol Hill earlier this month to enact the S-Corporation ESOP Promotion and Expansion Act (S. 3803). Among other provisions, the bill would extend to S-ESOPs owners a tax benefit now enjoyed only by C-corp. sellers: the ability to invest sale proceeds in other securities and, thus, defer capital gains tax.

“We’re seeing a very high level of interest in ESOPs,” says Kelly Finnell, president of Executive Financial Services, Memphis, Tenn. “A PricewaterhouseCooper study showing a 250% growth in ESOP transactions from 2007 to 2009 just about perfectly matches our own experience.”

A key factor behind the growing demand among business owners for using an ESOP as a succession plan, sources say, is demographics: a first wave of 79-plus million baby boomers are now edging toward retirement. Each morning, more than 8,000 boomers–among them business owners looking for an exit strategy–wake up to their 60th birthday.

Also fueling the upsurge is a still-difficult credit market for third-party acquisitions. In the wake of the 2007-2009 recession, observers note, financial institutions remain wary of extending business loans. ESOP transactions, too, experienced a lull during the downturn because of depressed valuations for firms and because business owners were more focused on surviving the crash. But with the economy now in recovery, ESOP transactions are back on a growth path.

Underpinning the ESOP’s growing appeal are tax benefits–a consideration that will take on added importance in 2011, sources point out, given the pending rise in income and capital gains tax rates; and, absent Congressional action, the expiration of tax cuts enacted under President George W. Bush in 2001 and 2003.

“Almost everyone expects tax rates to go up–significantly–making the tax benefits that much more valuable,” says Finnell.

Beyond offering the ability to defer tax on capital gains (an option available to C-corp. owners who sell 30% or more of their shares in the business) and deduct dividends paid on ESOP-held stock, ESOPs also let participating employees avoid tax on the stock allocated to their accounts or on earnings until distributed–generally at death, disability, retirement or termination of service (subject to vesting).

Companies that sponsor ESOPs also are able to deduct ESOP contributions (subject to certain limitations). That allows them to convert what would otherwise be a non-tax-deductible principal payment on a loan into a tax-deductible plan contribution.

The latter benefit is a key consideration for key employees who will manage the business and who may, as an alternative to an ESOP, entertain buying the company without the participation of lower-ranking employees.

In a study commissioned by the Oakland, Calif.-based National Center for Employee Ownership, which compared an ESOP to a key executive acquisition of a firm with 100 employees and five principals, the ESOP comes out a clear winner, according to National Center Founder Cory Rosen, “When you figure in the pre-tax versus after-tax benefits of a sale, executives are better off being a participant in the ESOP than they are buying the company outright,” he says. “The ESOP is vastly superior for tax reasons as a transition vehicle.”

Hilary Schneider, CEO of ESOP Corporate Resources, Newport Beach, Calif., agrees, adding the various tax advantages, plus the fact that shares in the business can be sold in stages (allowing the owner-seller to maintain control) makes an ESOP equally attractive for the seller.

“It doesn’t get any better for selling shareholders than to sell some or all of their stock, pay no capital gains tax on the sale, maintain management control and get a corporate tax deduction,” he says. “Weighed against other exit planning strategy, there isn’t much of a comparison.”

So far, so good. But before proceeding a with an ESOP sale, the seller and successor owners have to decide how to fund a key plan provision: the repurchase of stock from departing employees.

In many instances, observers say, the preferred solution will be permanent life insurance. One reason is the vehicle’s tax-favored wrapper: Policy cash values used to cover repurchase obligations grow tax-deferred. And flexible premium universal life insurance, the policy type most commonly used for an ESOP, generally offers a predictable rate of return.

Life insurance is also used to fund non-qualified plans for key executives, including deferred compensation plans, bonus plans, group carve-out plans and split-dollar life insurance plans, as well as to provide for the continuity of the business in the event of a key person’s death.

“Usually, the most valuable assets in the company are managers with the intellectual capacity, experience or longevity needed to sustain the business, says Philip Harriman, a chartered financial consultant and partner at Lebel and Harriman LLP, Falmouth, Me. “If such key people were to pass away, the value of the stock could be significantly harmed. Also, the lender funding an ESOP may insist on key person life insurance to ensure a bank loan funding the sale will get repaid.”

Life insurance, sources add, is increasingly used in seller-financed deals in which the owner receives a promissory note in exchange for the transfer of stock to the company. In the event the seller should die before the purchase price is paid, the policy death benefit can cover income or estate tax owed on the note and to provide for the deceased’s family members.

“Whenever you have a company debt, you almost always want life insurance to cover that debt,” says Rosen. “If I sell $5 million in stock to the ESOP, and take back a promissory note from the company, I’ll want to be sure my family is protected in the event of my death. That’s the first use of life insurance in these transactions: to cover the debt of the leveraged ESOP.”

Tim Cleary, a vice president of retirement and investor services at Principal Financial, Des Moines, Iowa, says such seller-financed transactions have become commonplace since the downturn, in part because of tightened credit markets for bank loans that otherwise would be used to fund ESOP transactions.

Cleary also notes that more businesses are moving to 100% ESOP-owned S-corps to be eligible for key IRC provisions: Owner-employees don’t pay income tax on ESOP earnings until they redeem their shares; and because the employee stock ownership trust, like all qualified retirement plan trusts, is tax-exempt, it’s portion of the company’s income is free from tax.

But Rosen observes that because 100% S-ESOPs enjoy tax-favored status, using life insurance for cash accumulation to cover repurchase liabilities makes little sense, as one would be placing one tax-sheltered vehicle inside another–a redundancy that is like putting an annuity inside an IRA.

Whether or not life insurance is part of a sale, market-watchers say, the advisor who is quarterbacking the deal won’t want to do without a savvy team of professionals experienced in key components of an ESOP transaction. Among them: an independent specialist to appraise the value of the business; a trustee to create and administer a profit-sharing trust and do due diligence on the sale on behalf of employees; plus an attorney and investment advisor to consult on legal and financing aspects of the transaction.

But it will likely fall to the insurance and financial professional to counsel on the most critical decision: whether to proceed with the ESOP sale, the cost of which can range from $50K to $150K. If, say experts, the business is not generating enough cash flow to justify the expense, has insufficient collateral to cover a loan or is in an industry that experiences high employee turnover, then the seller should explore other options.

An ESOP sale would also be ill-advised, observers warn, if the business has cultivated a hierarchical structure that doesn’t lend itself well to employee ownership–or to employee input on management decisions.

“It doesn’t make any difference whether the employees have a say in how the company is governed at a strategic level,” says Rosen. “What does matter is having a team-based management approach where employees can offer ideas about the work they and their colleagues do. Those businesses perform vastly better with an ESOP than do companies with traditional management structures.”