Employee Stock Ownership Plans Deserve a Close Look for Furniture Business Transition: Part One
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by Corey Rosen, Founder, National Center for Employee Ownership
One of the most difficult problems for owners of closely held businesses is finding a way to turn their equity in a business into cash for retirement or other purposes. The decision to sell is more than an economic one, however. After putting years into a business, owners develop a strong feeling of identity with the company. At the same time, owners often have a sense of loyalty to the employees and would like to see them have a continuing role in the company.
For some business owners, the answer to these problems will be to turn over the company to an heir or sell to a competitor. But many owners do not have heirs interested in the business, and outside buyers are not easy to find. Even if they can be found, they may want to buy the company for its customer lists, technology, or facilities, or may just want to put a competitor out of business.
In 2011, for instance, Steve Silver Company became a 51% ESOP. The company, founded in 1986 by Steve Silver in Forney, Texas, is a wholesaler of value casual dining and occasional furniture with over 2000 customers and 275 employees. Silver decided that an ESOP was the best was to preserve the legacy of the company and reward employees while at the same time providing a fair price for his shares. The company takes employee ownership seriously—in 2014, it won the National Center for Employee Ownership Innovation Award for the way its uses its company-wide innovation teams and cross-functional teams to encourage employee owners to come up with ideas to create growth.
So what is an ESOP? An ESOP is a kind of employee benefit plan, similar in many ways to qualified retirement plans and governed by the same law (the Employee Retirement Income Security Act). ESOPs are funded by the employer, not the employees. Stock is held in a trust for employees meeting minimum service requirements and allocated to employees based on relative pay or a more level formula, then distributed after the employee terminates. ESOPs cannot be used to share ownership just with select employees, nor can allocations be made on a discretionary basis.
With strong bipartisan support, Congress has intentionally made ESOPs the most attractive way to do a business transition. First, the money used to fund the ESOP is tax-deductible. Normally, when a company redeems its shares, the expense is not deductible. So if an owner wanted to sell $3 million of stock, the company might need to earn about $5 million in pre-tax profits to have the $3 million left over. With an ESOP, only $3 million is needed.
Moreover, for the owner of a C corporation (or a company that becomes one prior to the sale), proceeds on the gain from the sale to the ESOP can be tax-deferred by reinvesting in the securities of other domestic companies. If these securities are not sold prior to the owner's death, no capital gains tax is ever due. The sale can be all at once or gradual, for as little or as much of the stock as desired. For the employees, no contributions are required to purchase the owner's shares. The owner can stay with the business in whatever capacity is desired. The plan is governed by a trustee who votes the shares, but the board appoints the trustee, so changes in corporate control are usually nominal unless the plan is set up by the company to give employees more input at this level.
If the company is an S corporation and does not convert to C status, the tax deferral is not available, but there is a special benefit for S corporations. Any profits attributable to the ESOP’s share of ownership are not taxable. So if the ESOP owns 30% of the shares, 30% of the profits are not taxable; if it owns 100%, no taxes are due. Many companies start as a C corporation to do the sale and get the tax deferral then convert to S status.
In part two of this series, I will look at how ESOPs are financed and the rules they have to meet. In part three, I will look at how to determine if you are a good ESOP candidate. Finally, in part four, I will look at how employees can become owners if you do not use an ESOP.
About Corey Rosen:
Corey Rosen is the founder of the National Center for Employee Ownership, a nonprofit information, membership, and research organization. Details on ESOPs can be found at www.nceo.org
Employee Stock Ownership Plans Series
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