Employee Stock Ownership Plans, or ESOPs, are a great option for many snow and ice management businesses – and their owner/shareholders. Although controversial and somewhat complicated, the National Center for Employee Ownership (NCEO) estimates that today there are approximately 6,500 ESOPs covering more than 14 million participants.
About two-thirds of today’s ESOPs are used to provide a market for the shares of a departing owner of a profitable, closely held business. Most of the remainder are used either as a supplemental employee benefit plan or to borrow funds in a tax-favored manner. Less than 10% of ESOPs are in publicly traded businesses.
While ESOPs are not for everyone, they are a viable strategy for owners who sell their businesses to employees. ESOPs motivate employees, increase productivity, improve worker retention, contribute to a business’s longevity, and much more.
Overseen by both the IRS and the U.S. Department of Labor (DOL), ESOPs are usually funded by employer contributions of stock in the incorporated snow removal business, Or, as an alternative, employees are allowed to buy shares of stock as part of an investment program. With an ESOP, employee participants own part of the business through a retirement savings arrangement. At the same time, the business and its existing owner(s) benefit from a number of tax breaks, an extra-motivated workforce and, potentially, an effective succession plan.
When an ESOP is established, a trust fund is created to which owners contribute the shares of stock or money used to buy the stock. Or, borrowed funds are used to buy the stock initially after which contributed cash is used to repay the borrowed funds.
The shares in the trust are allocated to individual employees’ accounts, often using a formula based on their respective compensation. Naturally, the snow removal and ice management business must formally adopt the plan and submit plan documents to the IRS.
Dividends paid on the ESOP stock are passed through to employees or used to repay an ESOP loan. So long as they are reasonable, those dividends may be deductible for an incorporated snow removal business. Dividends reinvested by employees in the ESOP’s company stock are also usually deductible by the business although employees should review the individual tax implications of those dividends.
It may come as a surprise to many, but S corporation ESOPs are not subject to federal income taxes. The ESOP trust is an S Corporation shareholder, which is not subject to income taxes. After all, S corporations are pass-through entities that pass through their income to shareholders to be included on their personal state and federal tax returns.
Since shareholders in an ESOP each report the flow-through income on their personal tax returns, it is a powerful tax advantage providing the cash flow needed for an ESOP to purchase the snow removal business from the selling shareholder(s).
Once the stock purchase has been completely funded, the additional cash flowing from the tax savings provides the snow and ice removal business with a cash flow competitive advantage over its non-ESOP counterparts.
The stock’s price when purchased by the ESOP’s trustee, or the tax-deductible amount the incorporated snow removal business can claim for stock contributed to the ESOP, cannot exceed the stock’s value as determined by an independent professional appraiser. What’s more, stock must be valued at least annually with participants informed about the value of the shares allocated to their accounts.
THE GENERAL RULES
Generally, it is the employer who makes most of the contributions to the ESOP. Employees may be permitted to make voluntary contributions or, in some cases, actually required to contribute. Annual filing of the IRS’s Form 5500, Annual Return/Report of Employee Benefit Plan, is required. What’s more, an enrolled actuary must sign the Schedule B of that Form 5500.
As employee ownership vehicles, as with most qualified retirement plans:
- Contributions to the ESOP are tax deductible
- Employees pay no tax on the contributions until they receive the stock when they leave the business or retire, and
- They can then either sell it (if it is publicly traded or if there is a market for it) or sell it back.
BENEFITS FOR BUSINESS AND WORKER
The benefits offered by ESOPs include, as mentioned, taxes, cash flow, productivity, and revenue benefits. Consider the following:
ESOPs allow a business owner to sell his or her business in 60-90 days with a built-in buyer, providing diversification and liquidity. And, at the same time, the business owner can continue to control the business.
ESOPs increase the after-tax proceeds of the sale for the seller, providing greater overall return than with many private sales
The cost of the sale is usually offset by tax benefits. ESOPs eliminate many of the business’s tax obligations, and
Employers can contribute and deduct more than under other retirement plans.
And don’t forget the benefits of an ESOP for the snow removal operation’s employees, including:
ON THE DOWNSIDE
Although a tax-advantaged ESOP is easy to create, its cost and the loss of control can make it unappealing. For example:
A snow removal business creating an ESOP usually faces high start-up costs as well as significant annual costs. Plus, to reap the substantial tax savings, businesses selling to a tax-advantaged ESOP face rigid tax laws.
ESOPs must comply with all requirements imposed on other types of defined-contribution plans and cannot be integrated with Social Security. What’s more, an ESOP that owns stock in an S corporation cannot deduct any accrued expenses for any participant, including retirement plan contributions based on accrued compensation
Not only do ESOP transactions face the IRS’s complex rules, but they are also subject to the regulatory scrutiny of the Department of Labor.
Thus, if an ESOP holds an S corporation’s stock, that ESOP’s participants indirectly own stock in the S corporation. These participants do not include accrued compensation in their income until the year in which they receive it and, therefore, the S corporation cannot deduct any compensation (including bonus or vacation pay) incurred to those participants. Naturally, the S Corporation cannot deduct any plan contributions for those participants that are based on accrued compensation
Owners using debt to cash themselves out are adding excessive financial risk to the snow and ice removal business
Owners selling to an ESOP rarely get the highest price because, by law, ESOPs cannot pay more than the fair market value of the operation’s stock.
While the advantages of ESOPs are numerous, it is important to understand that an ESOP is not a good fit for every snow and ice management business or every situation. The regulations governing ESOPs are complex and the cost of establishing and maintaining a plan may be greater than other types of retirement plans or financing options. Thus, knowledgeable legal, accounting and tax advice is critical.