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ESOPs

May 31, 2016

Employee Stock Option Plans (“ESOPs”) are IRS approved retirement plans that offer a great tax break for owners that sell their business to an ESOP. This can also be very advantageous to successors who will eventually control and run the business.

An ESOP is an employee benefit plan designed to invest primarily in employer stock or other securities. ESOPs belong to the same family of qualified employee benefit plans as profit sharing and money purchase plans and are subject to similar participation and antidiscrimination requirements.

The ESOP can purchase part or all of the company’s shares from the founder or controlling owner, with the participants sharing in the ownership of the stock held by the plan. If the acquisition is structured properly the desired successors could control the company with shares they own outside the plan, along with the shares attributed to them through the ESOP.

The big advantage of selling to an ESOP is that the capital gain on the proceeds can be deferred to the extent the proceeds are invested in stock or other public marketable securities provided at least 30% of the company’s stock is owned by to the ESOP.

One way the ESOP transaction can be structured is for a newly created ESOP to purchase 49% of the owner’s stock, with the balance (or some of the balance) being sold to the successors or given as gifts to children that might be taking over. This way the successors or family still will have absolute control.

The ESOP could borrow the money to pay for the stock. This creates a “leveraged ESOP.” The company’s annual tax deductible payments to the ESOP will correspond to what the ESOP needs in cash flow to make the annual interest and loan principal payments. Also, any dividends paid by the company on stock owned by the ESOP would be fully tax deductible! Note that by doing it this way the company is able to deduct the loan principal payments since the bank is being repaid from the ESOP, and not the company.

ESOPs are an IRS sanctioned tax strategy that should be considered by any business owner contemplating a sale or planning a transition to a successor that already works in the business.

There are compliance and technical details that need to be adhered to, but in many situations the benefits far out weight the added efforts. For further information you can contact me at emendlowitz@withum.com or Brian Lovett who assisted in the preparation of this blog at blovett@withum.com

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