An ESOP may benefit your business

An employee stock ownership plan (ESOP) is an important tool available to nursery owners. It can be used to buy shares of a departing shareholder, to borrow money at a lower, after-tax cost or to create an additional employee benefit. It may be a solution the nursery owners wish to explore.

An ESOP can be established and funded in many ways. Usually the business borrows funds that are loaned to the ESOP. The ESOP uses the funds to buy out the selling owner. Following the purchase, the nursery business makes annual tax-deductible contributions to the ESOP, which the ESOP uses to pay down the debt.

There are some benefits. For the incorporated nursery or business, all contributions to the ESOP are deductible, which means it is buying out the owner using pretax dollars. There is also a downside to ESOPs.

An ESOP’s inner workings

ESOPs are most commonly used to provide a market for the shares of departing owners of successful, closely held businesses, to motivate and reward employees or to take advantage of incentives to borrow money for acquiring new assets using pretax dollars. In every case, ESOPs are a contribution to the employee, not an employee purchase.

With an ESOP, the nursery business establishes a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. As an alternative, the ESOP can borrow money to buy new or existing shares, with the business making cash contributions to the plan to help it repay the loan. Regardless of how the ESOP acquires stock, contributions by the nursery are generally tax-deductible.

Shares in the ESOP trust are allocated to individual employee accounts. Generally, with few exceptions, all full-time employees older than 21 years participate in the plan. Allocations are made on the basis of relative pay or some more equal formula. As employees accumulate seniority, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100 percent vested within a period of three to six years, depending whether vesting is all at once, or gradual.

When employees leave the business, they receive their stock, which the business must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares.

Benefiting from an ESOP

As many business owners approach retirement age, they increasingly face the dilemma of how to cash out. Fortunately, ESOPs do not always mean relinquishing control of the nursery operation. Employees must, of course, be allowed to vote their allocated shares on major issues, such as closing or relocating. It is the business that decides whether to pass through voting rights on other issues. In publicly held businesses, employees must be able to vote on all issues.

Multi-function ESOPs

There are many reasons for creating an ESOP. Owners of privately held businesses can use an ESOP to create a ready market for their shares. Since almost all of the value of an owner’s stock in the nursery represents capital gain, the selling owner may reap the biggest benefit.

Under this approach, the business can make tax-deductible cash contributions to the ESOP to buy out an owner’s shares, or it can have the ESOP borrow money to buy the shares. In a regular (often called a C) corporation, once the ESOP owns 30 percent of all shares in the business, the seller can reinvest the proceeds of the sale in other securities and defer tax on the gain.

In other words, when the owner sells to an ESOP and reinvests the proceeds within a 15-month window, the gain on the sale is deferred until the newly purchased securities are sold. If the owner dies before selling those securities, the capital gains escape taxation altogether.

ESOPs are also useful to help businesses borrow money at a lower after-tax cost. ESOPs are different among benefit plans in their ability to borrow money. The ESOP borrows cash, which is used to buy company shares or shares of the existing owner or owners. The business then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are tax-deductible.

The ESOP also makes an excellent employee benefit. A business can simply issue new or treasury shares to an ESOP, deducting their value (for up to 25 percent of covered pay) from taxable income. Or, the business could contribute cash, buying shares from existing public or private owners.

In publicly traded companies, which account for about 5 percent of all ESOP plans and about 40 percent of all ESOP participants, ESOPs are often used in conjunction with employee savings plans. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level.

Negative ESOPs

Despite the many benefits offered by ESOPs, there is also a downside. For one thing, there is the question of whether you want your employees as co-owners. When an employee who is vested in the plan leaves the business, that employee is entitled to take company stock shares.

While the nursery business may be ready to take back its own shares, the employee is not required to sell to it. A disgruntled former employee could theoretically sell that stock to a competitor or worse.

Because an ESOP is a benefit plan, it is subject -- in combination with any other corporate retirement plan -- to contribution limits of 25 percent of payroll, looking at the first $225,000 (in 2007) each employee is paid. Many experts advise that at least 20 employees are necessary, because if contributions to the ESOP are not going to be enough to service the debt, the whole thing is unworkable.

Every business owner should also keep in mind that the tax benefits of an ESOP, particularly the owner’s deferral on gain, apply only to regular or C corporations. The laws do not allow ESOPs to be used by partnerships or most professional corporations. ESOPs can be used in S corporations, but they do not qualify for the rollover treatment and have lower contribution limits.

If an S corporation is involved, owners frequently think about converting to a C corporation to establish an ESOP. Recently, the IRS added to the woes of S corporations by issuing new, final rules for ESOPs owning S corporation stock.

S corporations and ESOPs

Despite the growing popularity of limited-liability companies or LLCs, the S corporation remains the most popular operating entity among small businesses. The S corporation is an incorporated business with a limited number of stockholders that elects in the manner of a partnership. The S corporation generally pays no taxes, instead passing on all capital gains, ordinary income, tax preference items and the like to shareholders who include in their personal tax returns the pro rata share of these items.

New IRS regulations are intended to ensure the special tax benefits afforded to ESOPs that hold S corporation stock do not extend to cases in which ESOP ownership is concentrated among a small number of owners.

Whether because of a concentration of ownership, or for a number of other reasons, ESOPs owning S corporation stock may face IRS disqualification. Should this occur, contributions made by the business to the ESOP are no longer deductible while an excise tax may be imposed on the ‘illegal’ contribution. Obviously, the new S corporation regulations make professional guidance more important than ever.

How much will it cost?

The cost of establishing and maintaining an ESOP can include both out-of-pocket expenditures and a number of subtle costs. Small businesses are required, for instance, to repurchase shares of departing employees and this can become a major expense.

What’s more, anytime new shares are issued, the stock of the existing owners is diluted. That dilution must be weighed against the tax and motivation benefits an ESOP can provide.

The actual cost of establishing and maintaining ESOPs varies but usually includes attorney’s fees, corporate valuations and the costs of obtaining financing. Many business owners pay, before the annual maintenance fees, at least $30,000. This is often far less than the amounts that would have to be paid to a business broker to sell the business.

An ESOP is an employee-benefit plan, set up specifically to own stock in the nursery business. Whether an ESOP is used to buy the shares of a departing shareholder/owner, to borrow money at a lower, after-tax cost, or to create an additional employee benefit, it is an option many nursery owners would be well-advised to discuss with their advisers.

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- Mark E. Battersby

Mark E. Battersby is a business writer in Ardmore, Pa.