THINKING OF SELLING YOUR BUSINESS?
AN esop CAN SAVE YOU MONEY
An ESOP is an employee benefit plan that invests primarily in employer
stock. Congress has legislated a host of tax incentives, briefly described
below, to encourage business owners to
take advantage of ESOPs.
SIX REASONS YOU MAY WANT TO CONSIDER AN ESOP
1) YOU
CAN GET A FAIR PRICE FOR YOUR STOCK
Many owners of closely
held businesses are unable to find a buyer who will pay a fair price
for their stock, especially if they are initially offering only a minority
block of shares. An ESOP provides a market for closely held stock, at a fair
price determined by an independent appraiser.
2) YOUR COMPANY CAN WRITE OFF THE EXPENSE OF BUYING YOUR STOCK
The Company can deduct
from taxable income the amount of contributions made to finance the purchase of
your stock by the ESOP (within limits). In a leveraged ESOP, this means
that the Company can, in effect, deduct interest and principal payments
on the loan used to purchase your stock. Without an ESOP, only interest
payments would be deductible. This savings boosts after tax profits and the
Company's ability to buy your stock.
3) ESOPS ARE VERY FLEXIBLE
ESOPs are very flexible. You can cash out all your shares immediately,
or you can gradually sell your shares to an ESOP over many years.
4) YOUR
PROCEEDS FROM AN ESOP STOCK SALE MAY BE TAX FREE
If you sell your stock
to an ESOP and reinvest the proceeds from the sale in stock of another U.S.
Company, your capital gain from the sale will not be taxed until you sell the
newly acquired stock. If you decide not to sell the new stock during your
lifetime, you will avoid taxation of the ESOP sale income entirely. This tax
"rollover" is only available if, after the sale, at least 30% of the Company
stock is held by the ESOP. Certain other federal requirements must also be met.
5) YOUR SUB-S COMPANY
ESOP PAYS NO UBIT TAX
You can provide your
employees and your company with the motivational benefits of employee stock
ownership without converting your S corporation to a C corporation. Employer
contributions are deductible for up to 15% of covered compensation. An ESOP in
combination with a 401(k) plan, allows the company match to be made in Company
stock. A Sub-S ESOP is not eligible for the expanded tax or dividend deductions
of a leveraged ESOP, nor the the capital gains rollover. And stock held by the ESOP is not taxed
while in the ESOP.
6) SALE
TO AN ESOP PRESERVES THE COMPANY'S INDEPENDENCE AND REWARDS
THE
PEOPLE WHO MADE IT A SUCCESS
You may be reluctant
to sell your company to a buyer with no ties to the community. Frequently the
sale of a local business to an outsider results in alienation of the work
force, curtailment of operation, sale of assets, plant shutdown, or relocation.
Sale to your employees through an ESOP may be the best way to ensure the
continued success of your business.
HOW AN ESOP WORKS
In a "leveraged"
ESOP, the ESOP borrows money and buys the owner's stock. The Company usually
guarantees the loan, and contributes enough money each year to enable the ESOP
to repay the loan. In a "non-leveraged" ESOP, the company
contributions are used by the ESOP to purchase stock each year, rather than to
repay a loan.
The company deducts the
contributions from its taxable income. The ESOP stock is allocated to employee
trust accounts and when employees retire they receive their shares, or the
cash value of those shares. There are many variations on this arrangement.
ESOPS are extremely flexible.
Mr. Fulton owns 100% of the
shares of Tool & Die, Inc., a Sub Chapter
C company worth $6 million. Mr. Fulton is getting older and would like
to sell his company and enjoy the proceeds. If
he sells to an outside buyer, he will pay taxes, perhaps at the 2028%
rate, on his net long term capital gain. If his original basis in the stock was
-0-, he would pay $1,200,0002,160,000
and keep $4,800,0003,840,000
after taxes.
If the company, instead of
an outsider, buys him out by borrowing money or using cash reserves, Mr. Fulton
faces the same tax sting. In addition, the payments will not be deductible to
the company and might impoverish it (perhaps making it impossible for the
company to complete a gradual buyout).
These problems can be
avoided if Mr. Fulton creates a company ESOP. The ESOP finances the purchase
with company contributions, or by borrowing from a lender, using stock as
collateral. The company typically would guarantee the loan. The purchase price
of the stock is set by an independent appraisal.
If Mr. Fulton initially
sells at least 30% of outstanding company stock to the ESOP, he can
"rollover" the proceeds of the sale into stock or bonds in U.S.
companies and avoid paying any tax on the proceeds unless and until he sells
that "replacement" stock. Any replacement stock that remains in his
estate until his death gets a stepped-up basis and the capital gain is never
taxed.
The company deducts the full
amount of contributions to the ESOP used to buy Mr. Fulton's stock, or to make
interest and principal payments, within limits, on a loan used to buy
Mr. Fulton's stock. If the company is taxed at a corporate rate of 36%, this
deduction would mean that $2,160,000 (36% of $6 million) of the cost of cashing
out Mr. Fulton would be paid out of company funds that otherwise would have
been used to pay taxes.
The stock is held in trust
for employees. When they retire or leave the company they are paid their vested
and allocated stock or the cash value of that stock, usually in installment payments
over five years (or longer if the company stock was purchased with borrowed
funds).
There are several
permissible vesting schedules so that employees who leave with less than five
years of service need not get any stock upon termination.
The net result is:
* Mr. Fulton defers (and
perhaps avoids) $1,200,0001,680,000
in taxes on his capital
gains. If he wishes, he can retain control over his company while he
gradually sells to an ESOP over many years.
* The company saves more
than $2.1 million by deducting the $6 million in ESOP
contributions used to buy stock. This savings over the years should strengthen
the value of company stock as the buyout proceeds, and enhance the ability of
the company to raise the cash needed to purchase the owner's stock.
* The employees become
"stockholders" in their company.
.
c:wd/espbl
msesop.doc
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91087
NOTES:
91087 - Changed 4) to read: ESOPs are very
flexible. You can cash out all your shares immediately, or you can gradually
sell your shares to an ESOP over many years. (Took out --There are a wide range
of legally acceptable control mechanisms.)
Added to #6 second line after 1986 tax act --
and proposed amendments, the lesser of $750,000 or
April 26, 1988 - Changed paragraph #6. Will
use for the Troy conference on the 28th. Changed the title (ESOP Mechanisms and
Tax Incentives) back to the original title. mary ann
April 27, 1990 - Changed paragrgraph #6. mary
ann
December 16, 1992 - erased last section on
page 3 'example - partial buyout and estate sale'
march 26, 1993 - updated number 3, number 6 nubmer 7 , entire example section
and deleted last two paras entirely. moved to speech dir too mab
May 16, 1994 -- minor changes to para 5. income
changed to proceeds and capital gain
September 20,1996 - various re: sub-chapter s
& c company- delete no. 3 and renumbered, added a new no. 5, delete no. 7,
in example made co. a sub chapter c
October 15,1995-minor change to pg. 2 delete
maximum .fvh
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