Most entrepreneurs view owning a business as part of the American Dream. And one way to share that dream is with Employee Stock Ownership Plans or ESOPs.
That may be a clumsy acronym, but it is a graceful way to incentivize employees by building their wealth and yours through a collective effort. It also has the added benefit of being a business succession plan.
Today’s post will tell you what ESOPs are, who they work best for, and some steps you’ll need to employ if you consider doing one in your business.
So, what is an ESOP, and why would you consider one?
Simply put, it’s an employee retirement plan where the ownership is placed in trust. The Trust buys all or a portion of the company for the employees. This typically occurs as a loan. The Trust then uses the company’s profits to pay off the loan, so employees gain ownership by their work, not by paying out of pocket.
The advantage to the employer is a built-in business succession plan that incentivizes employees. Because, at least in theory, the better job they do, the more they stand to gain.
Another advantage is the flexibility of the plan. Owners can sell any portion of the company they like. And profits on the employee-owned portion of the business are free from federal (and many state) income taxes.
That’s right. If you offer 50% of the business as an ESOP, no federal income taxes are paid on that portion of the profits. If you offer 100%, then all profits are tax-exempt.
Those profits can then be used to pay off the loan. If you are a visual learner, check out this video.
How do I know if an ESOP might be right for my small business?
There are some non-negotiables. First, your company must be set up as a C or S corporation. You also must be able to fund the plan.
And your business must be profitable. If it is, then an ESOP makes sense because earnings are used to fund it.
Finally, you must be willing to deal with some complexity. ESOPs, like all business succession plans, are not simple.
Foremost in those complexities are the people. The employees must want an ESOP, and all owners must want to transition ownership to them.
It sounds simple, but sometimes that is no small feat.
Steps in establishing an ESOP
If you’re still reading, you might be ready to consider an ESOP. If so, there are some basic steps.
The first thing to do is to build an advisory team. A CPA can act as your quarterback. Try to pick one familiar with ESOPs. Then, you’ll need an attorney. ESOPs, as mentioned earlier, are complex. So, both the CPA and attorney are necessary.
You need to hire a trustee for valuation and negotiation purposes. But a CPA may be able to fill this role, as well, although it is usually a trusted employee or committee.
From there, you’ll want to establish valuation, obtain funding, and implement a process to operate the plan.
The Bottom Line
ESOPs can be a great way to incentivize employees, build wealth, and implement a business succession plan. There’s more to ESOPs than can fit in a blog post. But, if you are still interested, keep researching using the links provided and contact a good CPA for more information and advice.