Are you looking for a smart way to exit your business while benefiting the managers and employees you leave behind? If so, you might consider an employee stock ownership plan (ESOP). This type of plan can be a tax-efficient technique for sharing equity with employees as well as a powerful retirement and estate planning tool.
Start with the basics
An ESOP is a qualified retirement plan, similar to a 401(k) plan. But instead of investing in a selection of stocks, bonds and mutual funds, an ESOP invests primarily in the company’s own stock.
ESOPs are subject to the same rules and restrictions as qualified plans, including contribution limits, minimum coverage requirements and nondiscrimination testing.
Build in flexibility
An ESOP can be an appealing alternative to selling on the open market. It offers flexibility in structuring the payout to meet your income needs after you sell. For example, you can receive a steady stream of funds to support your living expenses if you plan to retire after selling. Or you can structure income payouts to invest in another business if you’re not yet ready to hang up your hat.
ESOPs also can have a positive effect on employee morale, productivity and loyalty. Many employee-owners work harder, smarter and more efficiently than nonowner employees because they’ve got a stake in the business’s success. This can lead to faster growth, higher profitability and lower employee turnover rates — all of which may result in a higher selling price for your dealership.
You could also realize significant tax benefits by making an ESOP the centerpiece of your dealership succession plan. You’ll make tax-deductible contributions of cash or ownership shares to a trust that’s established when you set up the ESOP. Cash is used to buy ownership shares on behalf of employees. The employees will not have to pay income tax until they later take distributions from the ESOP (likely at a preferable long-term capital gains rate of 20%).
An ESOP can be a good succession plan for the dealer who has no children or relatives interested in taking over the dealership’s operations. It also can be attractive to a large dealership group that might be difficult to sell without splitting up the stores. An ESOP can help transition dealer ownership to a large group of owners and employees.
Choose your ESOP type
There are two different types of ESOPs: unleveraged and leveraged. With an unleveraged plan, the dealership will contribute cash or shares to a tax-exempt trust, as described above. With a leveraged ESOP, the ESOP borrows money from the corporation, its shareholders or third parties to purchase the shares, and then use the corporation’s annual cash contributions to service the debt.
Ownership shares in the ESOP trust are allocated to accounts set up for all participating employees, usually in proportion to their compensation. When the owner is ready to exit, the dealership can make tax-deductible contributions to the ESOP to buy out his or her shares. Or the ESOP can borrow money to buy the shares.
Consider future costs
The dealership must formally adopt the ESOP and perform other administrative duties, including submitting plan documents to the IRS. Annual business valuations also may be required to determine the current stock price.
You should carefully consider the potential costs — in both time and money — of setting up and maintaining an ESOP. For instance, private companies must repurchase the shares of any departing employees, which can be a major expense. Also, if the ESOP is ever terminated for any reason, there can be significant costs and tax penalties.
Not for everyone
An ESOP isn’t the right business strategy for every dealership. Discuss the pros and cons in depth with your trusted advisor or contact us.