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Retirement Planning > Saving for Retirement

Exploring the ABCs of an ESOP Transaction

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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.  

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[1] 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)

No employee ownership is created as a result of the initial transaction.  The ESOP trust holds $6 million of stock; but as collateral for the loan from the company, it is encumbered.  Employee ownership is created when a portion of the loan is repaid, which in turn unencumbers a portion of the shares. 

The company makes a retirement plan contribution to the ESOP annually.  At a minimum, the contribution must be large enough to cover the ESOP loan repayment obligation to the company.  The ESOP trust makes a payment to the company on the outstanding loan.  The full amount of the contribution is tax-deductible to the company as a retirement plan contribution (assuming it is within the Internal Revenue Code (I.R.C.) contribution limits). This has the practical effect of making the loan principal repayment tax-deductible, whereas typically only interest payments are deductible in a third-party sale arrangement.  For this $6 million transaction example, assuming a 40% combined federal and state income tax rate, $2.4 million in tax savings are generated.  In essence, over the course of the loan repayment, tax savings in excess of the interest deduction fund 40% of the purchase price.  

In addition to this tax benefit, there are a number of other potential benefits depending on how the business is structured, including:

  • Capital Gains Deferral—Generally, if the corporation is a C corporation and at least 30% of the company is sold to the ESOP, the owner may defer federal capital gains by taking advantage of an I.R.C. Section 1042 rollover.  To take advantage of this option, the proceeds must be reinvested in qualified replacement property (stocks or bonds of domestic operating companies), creating an opportunity for financial professionals.
  • Elimination or reduction of corporate income taxes—If the Corporation is an S Corporation, the earnings attributed to the ownership by the ESOP trust are not subject to federal income tax (the ESOP trust is a nontaxable entity).   Many states afford ESOPs the same tax treatment, allowing some 100% ESOP-owned S corporations to have no income taxes at the business level.
  • C Corporation dividend deductibility—Dividends paid to the ESOP trust of a C Corporation are tax-deductible if certain conditions are met.  This has the effect of making a nondeductible payment of dividends a deductible expense. 

As the loan is repaid, shares become available for allocation to participant accounts creating employee ownership.  It is important to note that the individual participants do not actually own stock; the trust owns the stock on their behalf. 

The annual contributions are summarized as follows:


There is a great deal of flexibility in structuring ESOP transactions, but there are two important common threads. Owners are able to:

(1)  Extract the business value out of future operating cash flows.

(2)  Use favorable tax treatment to help fund the transaction.

You don’t have to be an ESOP expert to share the benefits with your clients.  Understanding the basics of ESOP transactions can help you introduce the ESOP option to existing and prospective clients alike. If it’s a fit, you can bring in an experienced ESOP consultant and other professionals to handle the details.      

As the massive numbers of boomer business owners continue to face retirement, being armed with some ESOP knowledge gives you one more way to help meet their needs and very possibly grow your business.  

[1] Because this example is a minority interest there will likely be a slight discount from the $6 million full value but we are rounding up to $6 million for the sake of this illustration.


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