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Employee Stock Ownership Plans provide tax-advantaged benefits for business owners.

ESOPs (Employee Stock Ownership Plans) are tax-qualified employee benefit plans that double as tax-favored financing vehicles. The owner can sell all or part of his shares for a fair market price to the employees through an ESOP.

Most small and medium-sized businesses are well suited for ESOPs. Business owners considering setting up an ESOP should have a company that is valued at a minimum of $1 million with 10 or more employees and in good financial condition.

The ESOP is a powerful tax-planning tool that allows the owner to sell all or a minimum of 30 percent of her stock and defer or permanently avoid capital gains tax on any gain resulting from the sale. The ESOP provides a market for a closely held company's stock. By selling a portion of the stock, the owner is able to maintain control of the business and is able to take cash out of the business tax-free prior to selling the remainder of her stock to the ESOP or to a third party.

The employees benefit by having a 100 percent company-funded retirement plan, job security and more incentive than ever to increase their productivity since they benefit directly through increased value of the company stock allocated to the ESOP. The company benefits because by having an ESOP, it can significantly reduce its annual tax liability.

If the company does not have adequate cash resources to finance the purchase of the stock from the shareholder, which is usually the case, a company secures an ESOP loan from a bank to purchase the shares. The company is entitled to deduct the loan's principal payments as well as the interest on an ESOP loan within generous limits set by the IRS. In effect, the company pays back only two-thirds of the loan principal and the government pays the remainder by providing the tax deductions.

For the business owner to qualify for these benefits, he must meet three requirements. First, the ESOP must own at least 30 percent of the company stock after the owner's sale. Second, the owner must invest the proceeds into qualified replacement property within 12 months. Finally, the business owner's stock cannot be allocated back to any member of the family.

Taxes are deferred by purchasing qualified replacement property, which generally includes stocks and bonds of domestic operating companies. The taxable event occurs only when the business owner sells these new investments. Taxes can be avoided altogether if the business owner holds the new investments until her death. At that point, the heir pays tax only on the appreciation of the investment between the time of the business owner's death and the date of sale of the investments. Unlike 401(k) plans, employees make no financial contribution to the plan, but rather earn stock in the company. The plan is funded by company profits. Employees do not pay taxes on the value of their stock until they liquidate it, and many choose to further defer taxes upon liquidation by rolling the proceeds into an IRA. When employees retire or leave the company, they sell their stock back to the company for fair market value as determined by annual independent evaluations. The company has one year to pay an employee who retired, died or left from disability. If the employee leaves for other reasons, the company has five years to pay the employee.

Business owners need to assess whether the ESOP benefit is right for their company and employees. ESOP plans are more expensive than other retirement plans to set up and administer, but the tax savings more than compensate for the additional costs. In order to create an ESOP, the business owner must first learn about the plans through a financial adviser, banker or attorney who specializes in ESOPs. When the owner has chosen to set up an ESOP after consulting with his business advisory team (CPA, banker, attorney and investment adviser/broker), he would commission a thorough, independent valuation of his business to determine the value of the stock, assuming it's a private company, and re-evaluate the cost each year. The market determines stock value of public companies. In the majority of ESOP formations, obtaining suitable debt financing is an important factor. The trick is to find a bank or banker that is familiar with ESOP loans. Many are not and may be reluctant to approve a loan they do not fully understand.

In summary, the uses and benefits of establishing an ESOP for your company are:

¥ Tax advantaged method for financing for the purposes of business expansion, equipment purchases and to buy out a partner or to provide funds for a divorce settlement by redeeming the departing shareholder's shares.

¥ The owner can maintain control of the company while at the same time providing employees with the incentive to succeed. An ESOP can help to attract and retain qualified people.

¥ Providing a market for closely held company stock and selling it free from current capital gains taxation. ¥ Improved cash flow for the business due to tax advantages.


Clark is a senior vice president/founding partner with Regents Bank. She is familiar with and has funded many ESOP loans. To learn more about ESOP loans, contact her at (619) 446-5590.

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