As a closely held business owner, a substantial amount of your wealth likely is tied to the business. Of course, you want to retain as much of that wealth as possible to pass on to your family after you exit the business. If your business is structured as a corporation, the answer may be an employee stock ownership plan (ESOP). It can enhance tax efficiency, support business succession goals and help preserve wealth for future generations.

An ESOP in action

An ESOP is a qualified retirement plan that invests primarily in your company’s stock. ESOPs must comply with the same rules and regulations as other qualified plans, and they’re subject to similar contribution limits and other requirements.

One requirement that’s unique to ESOPs is the need to have the stock valued annually by an independent appraiser. Also, by definition, ESOPs are available only to corporations. Both C corporations and S corporations are eligible.

In a typical ESOP arrangement, the company makes tax-deductible cash contributions to the plan, which uses those funds to acquire some or all of the current owners’ stock. Alternatively, with a “leveraged” ESOP, the plan borrows the money needed to buy the stock and the company makes tax-deductible contributions to cover the loan payments.

As with other qualified plans, ESOP participants enjoy tax-deferred earnings. They pay no tax until they receive benefits, in the form of cash or stock, when they retire or leave the company. Participants who receive closely held stock have a “put option” to sell it back to the company at fair market value during a limited time window.

ESOP benefits

ESOPs offer many benefits for owners, companies and employees alike. Benefits for owners include:

Liquidity and diversification. An ESOP creates a market for your stock. By selling some or all of your stock to the plan, you can achieve greater liquidity and diversification, enhancing your financial security and estate planning flexibility. Acquiring a wider variety of nonbusiness assets with the sale proceeds can make it easier to share your wealth with loved ones, especially those who aren’t interested in participating in the business.

Tax advantages. If your company is a C corporation and the ESOP acquires at least 30% of its stock, it’s possible to defer capital gains on the sale of your stock by reinvesting the proceeds in qualified replacement securities. You can even avoid capital gains tax permanently by holding the replacement securities for life.

Control. Unlike certain other exit strategies, an ESOP allows you to tap your equity in the company without immediately giving up management control. You can continue to act as a corporate officer and, if you serve as the ESOP’s trustee, you’ll retain the right to vote the trust’s shares on most corporate decisions.

The company can benefit because its contributions to the plan are tax deductible. With a leveraged ESOP, the company essentially deducts both interest and principal on the loan. And, of course, both the company and its employees gain from the creation of an attractive employee benefit, one that provides a powerful incentive for employees to stay with the company and contribute to its success.

Beware of an ESOP’s cost

An ESOP can be a powerful estate planning tool for closely held business owners, but it’s important to consider the costs. In addition to the usual costs associated with setting up and maintaining a qualified plan, there are also annual stock valuation costs. Contact us at the form below to learn more about pairing an ESOP with your estate plan. You can also visit our related service page for more information on our estate planning services.

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