As baby boomer business owners move toward retirement, Employee Stock Ownership Plans are getting more and more attention. An ESOP provides a flexible way for owners to exit their businesses, as well as to diversify their portfolios in advance of retirement.
An ESOP often creates numerous opportunities for financial professionals as well, including helping clients with planning, investing and protecting assets. Unfortunately, many business owners have a limited understanding of these plans and their benefits. Gaining a basic understanding of the plans may help guide an initial client conversation.
ESOPs are qualified retirement plans that invest primarily in company stock. They were included in the Employee Retirement Income Security Act of 1974 with a key public policy goal in mind—to encourage broad capital ownership and enhance employee retirement readiness—and were afforded several key tax benefits that can make ESOPs a compelling option for many business owners.
While every ESOP transaction is unique, reflecting the specific needs of the business owner and the company, most transactions have several features in common. Let’s look at a typical scenario.
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Assume a company has one owner and is valued at $20 million dollars. The owner wants to sell 30% of the company—about $6 million—to the ESOP using a bank-financed transaction, which is a common structure.
The Initial Phase – Plan Formation
In the initial phase, which includes plan design, transaction structuring and financing, the company will want to assemble a team of professionals—legal, accounting, and ESOP consultants—to ensure the ESOP is built on a strong foundation.
As a qualified retirement plan, the steps necessary to establish an ESOP include:
- Creating a trust and appointment of trustee(s).
- Designing the retirement plan and drafting the plan document.
- Filing for a determination letter with the Internal Revenue Service.
In addition, an independent valuation of the business needs to be obtained.
In this example, there are several key elements:
- The company borrows from a commercial bank to finance the transaction
- The company loans the $6 million to the ESOP.
- The ESOP uses the proceeds to buy shares from the owner, using the shares as collateral for the loan.
The net result is that the company has borrowed against the future earnings of the business to allow the seller to monetize part of his or her ownership.
Annual ESOP Contributions (and the Tax Benefits that Make ESOPs Compelling)