By Kevin McPhillips
Are you aware that an employee stock ownership plan (ESOP) creates tax-free profits? That’s correct, and it can be used as both a tax strategy and a succession plan. This can be an extraordinarily valuable tool to assist your clients.
ESOPs are not a trick or a loop-hole device. They are a Department of Labor program developed in 1974 by Sen. Russell Long (D-LA) and economist Lewis Kelso. The goal was to create a deferred-tax program that would allow business growth and address the retirement concerns of workers. When employees leave a business via retirement or otherwise, they may cash in shares of the business and pay ordinary income, just like a 401(k).
So how does this work? A business owner can sell some or all of the company to his or her employees, but the employees pay nothing. Rather, the business takes a loan from a traditional source (commercial bank) to pay the owner. The federal government and Pennsylvania then waive the taxes on the profits for whatever portion of the business is owned by the employees. Because an ESOP is part of an ERISA-sanctioned trust, with employee shares held within that trust, the profits are tax free. Yet, very few tax professionals know or fully understand this option.
The benefits described above are for S corporations. However, there is a separate tax benefit for C corporations. It is the 1042 election. If a C corporation is sold to an ESOP, there are zero capital gains (federal taxes deferred) on the sale of the business, provided the proceeds are placed in qualified investments – essentially U.S. stocks and bonds.
For a selling owner, that represents an additional gain of up to 30%. Interestingly, if a C corporation sells and takes the 1042 deferral on capital gains, the new entity can convert to an S corporation the next day and take advantage of the tax forgiveness on profits.
Mario Vicari, director at Kreischer Miller and a national expert on ESOPs, says, “An ESOP is the most tax efficient transition strategy for an owner exiting their business. With the proper transaction structure and planning, the owner can defer 100% of the federal tax on the gain on sale and the S corporation profits of the company are tax free for the portion of the company owned by the ESOP.”
Let’s look at the example of NewAge Industries in Southampton, Pa. In 2006, second-generation owner Ken Baker needed to create some liquidity. He learned of an ESOP and sold 30% of the company to his employees through an ESOP.
Immediately, the company began to grow. Over the next 12 years the company share price grew over 1,100%. In 2019, Ken sold the balance of the company to the employees at a dramatically higher share price, reaped tremendous rewards, and NewAge is now a 100% tax-free company. Ken remains as CEO, managing all day-to-day operations. He even owns shares as an employee.
ESOPs are not for all companies. They are not an alternative to bankruptcy and are not ideal for organizations with fewer than 20 employees. Also, they work best if there is a positive relationship between management and rank-and-file employees.
The myth that ESOPs are dramatically complicated and costly is untrue. As you know, all transactions are complicated. ESOPs are simply a different kind of complicated compared to more traditional transactions. Those who take the time to learn more about ESOPs are able to offer appropriate clients a succession planning solution that provides liquidity when needed, a ready-buyer (their own employees), a productivity and growth strategy, preservation of legacy, continued control over operations, and an extraordinary tax strategy. It becomes another valuable solution that you can share with clients as part of your service offerings. Further, it is a definitive way to create real and immediate tax reductions. Here is another example.
In 1970, Lehman B. Mengel started a company in Selinsgrove, Pa., called LB Water. LB Water sold pipe and other products to contractors and builders in central Pennsylvania. Over the next 30 years, the company successfully grew to 40 employees. In 2002 , the owners of LB Water looked to sell the company, the offers entailed moving it out of Selinsgrove and laying off the employees. The owners did not wish to do that.
The owners learned about employee ownership, so they decided to sell the company to the employees through an ESOP. Incredibly, they sold the business to their employees for more than they were offered by other suiters. Fast-forward 15 years: not only did the business stay in Pennsylvania and all the employees keep their jobs, but LB Water boomed. Within those first 15 years as an employee-owned company, it grew from 42 employees to 202. Today they are well over 250.
The ability to grow so quickly and profitably was enhanced by the additional profits as a result of ESOP tax forgiveness.
My organization, the Pennsylvania Center for Employee Ownership, is a 501(c)(3) nonprofit that raises awareness about a remarkable program that can benefit business and business owners. We are a volunteer collective of CEOs, foundations, universities, and industry professionals. We do not provide accounting or professional services, but rather we are dedicated to simply helping to raise awareness about an important program.
If you would like to learn more about ESOPs and employee ownership, please visit www.OwnershipPennsylvania.org/CPA.
Kevin McPhillips is executive director and CEO of the Pennsylvania Center for Employee Ownership in Havertown. He can be reached at kevin@paceo.org.
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