How It Works In its simplest form, an ESOP transfers an owner’s shares in a company to its employees. Workers receive those shares over time through a vesting schedule based on their salary and seniority, which buys those shares back when employees leave or retire. The plan is free for workers; they don’t contribute any money to it. It can be set up at any time, and the owner can sell all, or part, of the company.
The transaction is typically financed by a bank, which lends money against the company’s future earnings. The company puts that money in an ESOP trust, which buys the owner’s shares and holds them until distribution. In fact, a “leveraged ESOP” — the most common kind — is pretty much identical to any other kind of leveraged buyout: your company takes on debt to buy itself and has to pay that money back down the road. That’s what Kilgore and her employee-owner colleagues did during the first seven years at Mid South Building Supply.
The good news is that the company can deduct both the principle and the interest while paying back the loan. And at an S-corporation, there’s no income tax on the percentage of stock owned by the ESOP, meaning that a 100% ESOP company pays zip to Uncle Sam come April 15.
There are advantages for the owner-seller of a C-corporation as well: if the owner sells 30% or more to the ESOP, he can defer taxes by reinvesting that money in stocks or bonds of other U.S. companies. Then, if he dies before cashing out, his heirs don’t pay any tax on the gains. Some owners sell stock in their C-corp. to defer taxes and then, after a few years, the company converts to an S-corp. to take advantage of those special tax benefits.
“Basically, you’re selling your company for pretaxed cash flow, and then you can defer the capital gains on the transaction indefinitely,” says Walter Zweifler of New York-based Zweifler Financial Research, which conducts ESOP appraisals to assign value to a company’s stock at the beginning of the process. “That can make a huge difference on the purchase price because you can cut it by 15% or 20% that you would otherwise have paid in taxes.”
One sticking point, though, comes from valuing the company in the first place, a step required by law to be conducted by an independent third party. Value it too high, and the company risks taking on too much debt. Value it too low, and an owner isn’t getting what he feels he deserves. “It’s very easy to overburden the company with ESOP debt,” Berenson says. “Obviously, that becomes an even more serious issue if you’re using a bank in terms of calling in the loan.” Owners should keep in mind that tax savings can make up for a conservative valuation, while ensuring the future health of the business.
How Much Will It Cost? The expense of setting up an ESOP can also be an issue. Feasibility studies, mandatory appraisals, and attorneys’ fees can run anywhere from $20,000 to $50,000 initially, with annual fees of $10,000 or more to conduct mandatory, periodic appraisals after that. “The downside of the ESOP is that it’s complicated, it’s expensive, and there are ongoing costs,” Berenson says.
While the leveraged ESOP is most common, you don’t have to use debt to set one up, especially if you have time before you retire. At Harrell Remodeling, a $7.2 million design/build company in Mountain View, Calif., owners Iris Harrell and Ann Benson set up their ESOP so that the trust only buys shares from them if the company makes money. “We aren’t leveraged at all, so if we have a bad year, we don’t do a transaction,” Benson says. “It’s probably the most conservative way to do it, and it only works if you don’t care when you retire.”
For example, after setting up the ESOP in 2001, Silicon Valley’s dot-com hangover resulted in the first loss in Harrell Remodeling’s 20-year history. While the company hoped to be more than 10% employee-owned by now, workers still own just 5.3%. Meanwhile, the ESOP cost almost $30,000 initially, and has cost $15,000 per year since then. Although still an enthusiastic proponent, Benson concedes that “it’s been a real slog.”