From the February 1997 issue of Entrepreneur

If you are one of the lucky small-business owners whose company has grown over the years, you may be looking for a tax-sensible way to glean equity from your efforts and diversify your holdings. You may also want a tax-favored way to pass along the company to heirs or others involved in your business.

An Employee Stock Ownership Plan, or ESOP, may be the answer. An ESOP is a tax-qualified, defined-contribution employee benefit plan that invests primarily in the stock of a company on behalf of its employees, who thereby gain an ownership interest in the firm.

Unlike most pension or profit-sharing plans, which must invest and diversify funds, the primary investment of the ESOP is the stock of the company sponsoring it. Today, there are about 10,000 ESOPs and similar plans nationwide covering some 11 million employees, says Scott Rodrick of the National Center for Employee Ownership (NCEO). Based in Oakland, California, this nonprofit membership and research organization serves as a central source of information on employee ownership.

A recent change in the tax laws relating to ESOPs may help boost that number. In the past, only C corporations were allowed to establish ESOPs. But with the passage of the Small Business Job Protection Act, the federal government has decided to allow S corporations to establish ESOPs starting January 1, 1998.

Ins And Outs of ESOPS

While ESOPs offer a number of key benefits for business owners and their employees, they take time, effort and money to establish. First, the plan must borrow or use available funds to buy shares from the current owner, or the business owner can contribute new shares. Employees, however, usually can't put up money to purchase shares.

Under federal rules, most full-time employees must be included in the plan, and a disproportionate share of the benefits from these plans cannot go to highly compensated employees. In a closely held company, the shares in the ESOP usually must be voting shares, allowing employees voting rights on major issues such as whether or not to liquidate, sell or merge the company.

ESOP shares are then held in a trust; each employee participating in the plan has an account in the trust. Stock remains in an employee's account until he or she leaves the company. The employee earns dividends on the shares but cannot sell the shares until after exiting the company. Employees are not required to pay taxes on their holdings until that time.

ESOPs come in two varieties: leveraged and unleveraged. A leveraged ESOP borrows money to buy stock. An unleveraged one is funded with cash contributions from the business, which are used to buy stock from the firm or from current stockholders. If the company's shares are not publicly traded, the purchase price of the stock is established by an independent appraiser paid by the company.

Tax Benefits APlenty

ESOPs appeal to many closely held business owners because they offer a tax-favored way to sell a company, raise capital and plan an estate, says Roland M. Attenborough, an expert on ESOPs and a partner in the Los Angeles law firm of Reish & Luftman. When ownership is transferred to employees through an ESOP, the pretax income of the corporation can be used to make the transfer, which represents a big savings, he explains. When a conventional transfer of ownership occurs, it is done with after-tax dollars.

How can ESOPs help raise capital? The company obtains funds from the sale of the stock to an ESOP, which has borrowed the money to finance the transaction. The business then makes tax-deductible contributions to the ESOP to repay the loan. Both the principal and interest on the loan are deductible.

Employers also can deduct dividends paid on ESOP-held stock if the dividends are paid in cash to ESOP participants, either directly or as payments to the ESOP that are distributed to participants within 90 days after the close of the plan year.

There is another tax benefit as well. The owner of a closely held company who is selling a portion of the business is not required to pay current tax on the entire gain of the sale if at least 30 percent of the business is owned by an ESOP.

To avoid the tax, however, the seller must use the proceeds to buy stocks or bonds of another U.S. domestic-operating company (excluding mutual funds and real estate investment trusts). The purchase of these stocks and bonds must take place within a 15-month period, beginning three months before the date of the sale.

This tax strategy is often referred to as a Section 1042 rollover, Attenborough explains. Any or all of the proceeds can be rolled over; the seller simply pays taxes on any amount that is not rolled over.

Using a Section 1042 rollover, the owner doesn't have to pay capital gains tax on the profits until the replacement securities are sold. In many cases, owners avoid taxation altogether by hanging on to the replacement securities until death. At that time, the owner's estate receives the securities on a "stepped-up" basis. This means the heirs are not responsible for paying tax on any gain that occurred before they inherited the securities, so federal tax is avoided.

To help facilitate the ESOP sale, the owner can pledge part or all of the replacement securities as collateral for the loan. This works especially well in companies with limited assets or substantial debt, says Rodrick.

While the tax advantages of ESOPs are extremely worthwhile, there are also other benefits to be gained. For example, ESOPs offer employees a valuable company benefit, which helps employers attract and retain good workers. Employee ownership also has been shown to boost worker motivation when combined with a participative management program, Rodrick says. With an ESOP in place, employees have an ownership stake in the business and a share in its financial success. As the company grows, their shares grow with it.

If you are planning to retire and are setting up an ESOP prior to exiting the company, Attenborough recommends being sure to put in place an adequately trained succession management team. That way, when you leave, the management team is ready to assume responsibilities.

Are ESOPS for you?

Even though the tax breaks and employee incentives are attractive, ESOPs are not appropriate for every company. As a rule of thumb, says Rodrick, ESOPs work best for companies with more than 20 employees and with sufficient cash flow to meet a number of ESOP-related expenses.

It's also important to consider whether you are willing to give up some ownership in the company. If you want to maintain a 100 percent ownership role, then an ESOP is not the way to go. But bear in mind, an ESOP still allows an owner to retain majority control of a business. "There is an opportunity for the owner to sell [part] of his or her shares and stay with the company even though a certain portion of the holdings are cashed out," says Attenborough. For example, if you own 100 percent of the business and sell 30 percent of your stock to the ESOP, that qualifies as a tax-free sale--and you still maintain control of your business.

There are other drawbacks to consider. For one thing, ESOPs can be expensive to establish: There are legal, accounting, actuarial and appraisal fees, which can total about $20,000 or more for a small or medium-sized firm. Annual expenses to maintain the plan in a closely held company generally run from $5,000 to $10,000 or more. Another expense is the requirement that private companies with ESOPs repurchase shares of departing employees--a responsibility that can create unexpected financial demands on a company's cash flow.

In addition, businesses establishing ESOPs must be ready to maintain an open dialogue with employees to reap the full benefits of the partnership. An effective communication program must be established, Attenborough says, so employees understand the advantages of their ESOP. As part of this openness, you must be ready to disclose certain financial information about the business, its performance and the salaries of key executives.

Despite these concerns, ESOPs have been shown to be very effective for everyone involved, especially when the business owner is committed to the idea of employee ownership. Overall, for many businesses, the pluses far outweigh the minuses.

For more information on employee ownership, visit the National Center for Employee Ownership Web site at (http://www.nceo.org).

Joan Szabo is a writer in McLean, Virginia, who has reported on tax issues for more than 11 years.

Contact Sources

The National Center for Employee Ownership, 1201 Martin Luther King Jr. Wy., Oakland, CA 94612, (510) 272-9461;

Reish & Luftman, 11755 Wilshire Blvd., 10th Fl., Los Angeles, CA 90025, (310) 478-5656.