Raising Business Capital With An ESOP: Give The Staff A Stake - 1st Source

If you’re a business owner looking to raise some capital, an Employee Stock Ownership Plan (ESOP) is an excellent option. It helps you raise the money you need, and it has other benefits for your company. It gives your employees a stake in the business, providing incentive to work productively and to stay with the company long term. There are also significant tax benefits which we will address a little later.

How does it Work?

Shares in the business can be granted as a bonus, they can be distributed as an incentive, they can be “gifted” or employees can purchase shares directly from the company, saving on brokers’ commissions. Those stock purchases can be made directly or through payroll deductions.

At some companies, an ESOP functions like a 401(k) plan, except employees buy stock in the business. Some ESOPs allow account holders to borrow money against the value of stock in an individual account.

Setting up an ESOP

The benefits of an ESOP are transparent and easy to measure. However, planning to create an ESOP takes some time, thought and expertise since there are tax reporting implications and employee/employer relationship implications.

It’s a good tool for small companies enjoying regular growth. It’s also a great benefit to attract the best talent to well-established companies that have seen sales and revenues plateau. Looking for new expansion and productivity innovations? Offer an ESOP, but do it right.

The Right Corporate Structure for an ESOP

Sole proprietorships or partnerships aren’t typically the best corporate structure to create an ESOP because there are too few owners, and often, too few employees.

A C-Corporation or S-Corp, either of which allows the stock to be sold, is the better way to structure your company. Keep in mind that if you have more than 100 participants in the company ESOP, a C-Corp is your only option according to the federal tax code. Or, if you anticipate hiring in the future, your ESOP will always be limited to 100 participants within an S-Corp, so a C-Corp might be the best to go.

In either case, the key is to create a corporate structure that pays corporate taxes rather than personal taxes. Why the emphasis on taxation benefits?

Tax Advantages

  • Employee contributions (purchases of stock) are tax-deferred, like 401(k) contributions.
  • Stock donated to the plan by the company is tax-deductible by the company in the year the donation is made, cutting your tax liability as you spread the wealth among employees.
  • The stock sold through an ESOP is sheltered from capital gains tax on share price appreciation – another benefit and an incentive for employees to invest in, what is now, their company.

The more tax your business or your employees pay currently, the greater the tax benefits provided by a sheltered ESOP. And that’s good for the employees and for the company.

Raising ESOP Funds

So, how does your business raise expansion capital when it creates an ESOP?

One way is by issuing or selling new shares of stock to the ESOP. The ESOP borrows the funds needed to pay for the stock, and your business uses those funds for growth initiatives, such as hiring new staff, expanding your service area with a satellite office, or adding new product and service offerings.

Since an ESOP is overseen by an impartial trustee, like your bank or a family of mutual funds, the ESOP may be approved to borrow money, based on the company’s credit history, in order to finance expanded employee ownership in the business. The result is a “leveraged” ESOP, or an ESOP that has borrowed funds to purchase shares of stock. Those shares of stock are granted to employee accounts – an immediate benefit to your dedicated business team. It is a bonus that creates goodwill, increased productivity (think “fewer sick days”) and employee loyalty.

Another advantage to creating an ESOP is that borrowed funds are invested and repaid using pre-taxed dollars, not post-taxed dollars, generating significant tax savings for the business and its employees. In effect, the federal government contributes to the growth of the ESOP value and to your company’s ever-growing success.

A leveraged ESOP can also re-purchase shares from owners who retire or otherwise leave the business. This assures business continuity. The ESOP – a distinct, legal entity – buys out an owner leaving the company to avoid outsiders from taking an undesired ownership stake. Shares are bought at market value, the retiree receives cash and employees maintain control of business activity and ESOP management.

Advantages of an ESOP

  • An ESOP recovers a portion of previously paid taxes when amended returns are filed.
  • An ESOP enables a business to refinance existing debt and take deductions for principal and interest payments that are made with pre-taxed dollars, saving the business money while keeping employees happy.
  • An ESOP generates “in-house” expansion and working capital that creates additional cash flow, unlike 401(k) plans that reduce the amount of cash available to a company for growth and operational expenses.
  • An ESOP creates a tax deduction without an accompanying expense. Savings can be used for any purpose, including lowering prices of goods and services to stay competitive in tight markets. Management has more maneuvering room.
  • An ESOP reduces the cost of employee retirement and pension benefits, and trustee oversight costs that can run as high as 2%-3% of the total value of assets under trusteeship.
  • An ESOP provides an incentive for employees to contribute to the success of the company since participating employees are part owners of the company.
  • An ESOP is a benefit that employees recognize, keeping staff in place and lowering hiring and recruitment costs.
  • Because employees have a stake in the business, productivity increases organically because employees understand that their futures are tied to the success of their business. ESOPs create employee loyalty in way no other retirement or ownership plan can.

Company ownership is always a morale booster. Expect lower healthcare costs, excellent ideas from the production floor to the boardroom, and employees who want the company to succeed as much as you do.

Disadvantages of an ESOP

There are some disadvantages to an ESOP, but the advantages far outweigh the downside.

  • An ESOP dilutes the ownership stake of the original owners because additional stockholders are created. Your employees are now owners.
  • An ESOP may create liquidity problems when stock value appreciates significantly. When employees retire, the company may not have sufficient cash reserves to repurchase the retiree’s shares of stock at the time of retirement.
  • An ESOP may actually lower employee motivation if company performance is poor and the value of the company shares flat lines or decreases. Employees may turn to other sheltered retirement plans like an IRA or Roth IRA in which the employee controls where and how savings are invested.

Creating an ESOP

The process of establishing an ESOP starts with a company valuation to determine the accurate and true value of the company. Then, company management, with the advice of legal counsel, creates the ESOP by filing the proper paperwork with federal and state taxing agencies.

The ESOP is created as a trust that purchases company stock. The ESOP trust owns the stock and distributes shares to individual employee accounts.

After the company tax attorney drafts the ESOP plan and submits it to the IRS for approval, Internal Revenue Service approval comes in the form of a “letter of determination.”

If the IRS does not agree to all the provisions of your plan, your attorney amends the plan as necessary to meet IRS guidelines and requirements.

The ESOP is then administered by an impartial trustee, your commercial bank for example, and is directed by a committee of employee owners.

The accounting and tax regulations for an ESOP are straightforward, but this is a legal entity so the regulations can be fairly detailed. That’s why it’s good business to hire a professional financial and legal consultant to ensure your ESOP meets the needs of your business, your employees, and of course, all tax and regulatory agencies. 1st Source Bank can help you establish an ESOP and answer any questions you may have about starting one. Please give us a call at (574) 235-2000 or inquire online at 1stsource.com.

Bottom Line

If you get it right from the start, an ESOP can provide significant benefits for your business. Your company will have access to capital for expansion, enjoy tax benefits, and have employees who are stakeholders in the business.