An employee stock ownership plan (ESOP) can be an appealing option for business owners looking to transition out of their companies. It’s particularly attractive for owners who don’t plan to transfer their business to children or other family members, but are reluctant to place their legacy in the hands of a third party.

In addition to providing a valuable employee benefit, an ESOP allows owners to transfer the company to their employees in the most tax-efficient manner possible. Unlike a management or employee buyout, in which employees acquire the company with their own after-tax funds, an ESOP finances the purchase with pre-tax corporate profits.

How It Works

An ESOP is a qualified, defined-contribution retirement plan, similar to a 401(k) or profit-sharing plan, that invests primarily in the sponsoring company’s stock. The company makes tax-deductible contributions on behalf of covered employees — usually all full-time employees — up to 25 percent of covered payroll.

As with other defined-contribution plans, ESOP contributions are often subject to a vesting schedule based on employees’ years of service. Employees pay no tax on the stock allocated to their accounts until it’s distributed. When employees retire or otherwise become eligible for distributions, they receive the vested portions of their accounts in stock or cash, either in a lump sum or in installments. Employees who receive nonpublic stock have a “put option,” which allows them to sell the stock back to the company for fair market value during specified time windows. Private companies that sponsor ESOPs must have their stock valued annually by an independent appraiser.

Benefits for Owners and Companies

An ESOP allows owners to sell their shares in a highly tax-advantaged manner. If the company were to redeem their shares, the purchase would have to be made with after-tax dollars. But an ESOP allows the company to finance the purchase with tax-deductible contributions. And if an owner wishes to sell more shares than the contributions will cover, the ESOP can borrow the money it needs to buy his or her shares and the company’s annual contributions are used to make the loan payments. This type of “leveraged ESOP” provides an enormous tax advantage: Because ESOP contributions are tax-deductible, the company essentially deducts both interest and principal on the loan.

In addition, if the company is structured as a privately held C corporation and the ESOP ends up with at least 30 percent of its stock, owners who have held their stock for at least three years can defer any capital gains by reinvesting the proceeds in qualified replacement property (QRP) within one year. QRP includes most securities issued by domestic operating corporations.

Tax deferral isn’t available to owners of S corporations, but S corporation ESOPs offer another valuable benefit: Profits allocable to shares held by an ESOP are exempt from federal income taxes and most state income taxes. So, if an ESOP owns 100 percent of an S corporation’s shares, the corporation escapes federal (and, usually, state) income taxes altogether.

Another advantage of an ESOP is that it allows owners to divest themselves from the company without giving up control right away. That’s because stock sold to an ESOP is held in a trust until it’s distributed to employees, and the trustees, who can include the selling owners, continue to vote the trust’s shares on most corporate matters.

Plan Your Exit

If you’re a business owner looking for an exit strategy, an ESOP is worth a look. ESOPs are available only to corporations, so owners of partnerships and LLCs should weigh the costs of converting to a corporation against the potential benefits of an ESOP.