How to avoid pitfalls of employee stock option plans while reaping tax, retirement benefits
Thinking about retirement? For those who own a company and are looking to hand control to their employees, an employee stock ownership plan, or ESOP, might be an attractive option, but it doesn't come without risks.
The plans allow a company to set up a trust fund to which employees can contribute cash to purchase company stock, contribute shares directly, or have the plan borrow money in order to purchase shares in the company. If the plan borrows money, the company contributes to it to enable it to repay the loan.
A central benefit of ESOPs are that the contributions are not taxed until employees receive their stock when they leave or retire, and owners can sell out of a business over time.
But the plans do carry risk, particularly for owners who risk losing control of their company as they gradually offload shares to employees. It is also possible a business would not generate enough cash to buy out the owner. Employees also see risk, since if a business goes belly up, their retirement savings potentially do, too, with an ESOP.
We asked North Bay experts to weigh in on the pros and cons of ESOPs from the ownership and the employee perspective. Contributors include Kimberly Hunter, a private wealth financial adviser, managing director for investments at Wells Fargo Advisors; Claudia Stern, a principal in the Forensic and Financial Consulting Services Group at Hemming Morse LLP; Jim Andersen, a CPA and partner at Hemming Morse LLP; and Lillian Meyers of Meyers Financial Services, Inc. Some answers have been edited for clarity.
How can ESOPs be used in business succession planning when an owner is looking to leave a business?
Kimberly Hunter: Employee Stock Ownership Plans can offer a business owner a tax efficient way to exit the business and sell the business to their workers over time.
Lillian Meyers: Employee stock (ownership) plans are a good option if your family is not interested in your business. A plan can be set up to have your employees own the business. ESOP is a qualified retirement plan subject to the regulatory requirements of the Employee Retirement Income Security Act of 1974 (ERISA). One big difference you must note, the retirement plan must have more than half of the investments in your company stock.
As I work with my clients and working a plan, I always let my clients know that there are always pros and cons to any financial decision you are planning - a positive or negative that happens - and it is important to look at the whole picture.
One of the options that is attractive to your employees is control but the disadvantage to you is the loss of control. You do have a maximum up-front liquidity and the control of the premium.
If you want to stay involved with your company you may have options as the seller to continue to be involved.
Claudia Stern and Jim Andersen: If an owner decides that the business should be transferred to the employees, this is a tax-efficient mechanism for getting the business to buy out the owner and for the employees to take control.
Because the business is the one cashing out the owner, it is imperative that the business have adequate cash flows to support the buy-out. One of the downsides of this method is that the owner may get paid less for the business because they are selling at fair market value and losing the opportunity to achieve a synergistic sale which would generate a premium over fair market value.
The other downside is that the owner may not be able to sell their entire stake at once, so there is risk that the business may not generate enough cash in the future to complete the entire buy-out process.
What are the advantages of this approach as opposed to other methods?
Hunter: The owner can get cash out of the business to retire and diversify while the employees can purchase the business using loans with tax benefits. Therefore, it truly can be a win-win for the business owner and the employees.
Meyers: When you take advantage of leveraging assets to purchase shares, the company conducting the ESOP sells 25% to 100% of the company to its employees. The owners are selling the company to itself. You create equity incentive to all participating employees who want to become owners, so the mindset is to ensure the company is successful. This can also work for recruiting and retaining great employees.
One important aspect is to check out the tax deductions when the company contributes to the plan and the deferral of capital gains to the redeeming shareholders, leading to cash flow.
You must be ready to deal with compliance issues and the recording of the shares. Also, it's important to consider the tax laws dealing with ERISA which leads to needing a professional to manage your plan.