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Succession Planning Using ESOPs

Posted: Farrah Gandhi

As seen in the Fort Bend CEO magazine

One of the greatest sources of wealth in America is ownership of small businesses, those created by entrepreneurs risking their own capital to try and build a business with real value, usually from nothing. After spending years creating and nurturing the growth of the business, most owners want to recognize the value they have created. Succession planning is the process an owner should undertake to recognize the value in his or her business. We wrote a previous article discussing the mistakes to avoid in business succession planning. In this article, we focus on Employee Stock Ownership Plans (ESOPs), a powerful tool that can be used in succession planning.

ESOPs are qualified plans established by the United States tax code. They are essentially the same as profit sharing plans, except for one major difference – ESOPs own the stock of the employer sponsoring the plan while profit sharing plans do not. Just like profit sharing plans, all contributions to an ESOP are tax deductible to the business, and earnings inside the ESOP grow tax-deferred.

Contributions to the ESOP are usually allocated pro-rata based on each employee’s compensation. The highest paid employees (usually the owners) get larger contributions than the lower paid employees. Contributions are invested in the employer’s stock, but also can be invested in just about any publicly traded stock, bond or mutual fund. Employer contributions also are subject to vesting, like profit sharing plans. Finally, unlike a 401(k) plan, employees do not directly contribute to the ESOP.

The ESOP, just like any owner of stock, can transact with other owners. This means the ESOP can sell or more typically buy stock from other owners. Think how advantageous this arrangement might be for a large owner of small company stock. An owner can contribute company profits to the ESOP (avoiding tax) and use the profits to purchase his own stock. The stock sale is taxed at the capital gains rate. There also exists a provision in the tax code that permits owners to sell stock and defer capital gains indefinitely.

We are often asked if establishing an ESOP means giving up control of the company. The answer is an emphatic no! Shares contained in the ESOP are controlled by the trustees of the ESOP, not by the participating employees. In most cases, the owners of the firm appoint the trustees of the ESOP. You can see that by appointing the appropriate individuals as trustees, the owners or managers of the company can maintain control of the company, even if the ESOP is a majority owner.

Also important is that when properly used, the ESOP can be a motivator for employees, as they will have a very tangible stake in the success of the company and the growth of the value of its stock.

Just like any succession planning strategy, ESOPs are not appropriate for everyone. You should work with someone qualified in succession planning and ESOPs to determine if they may be appropriate for your small business.

WJ Interests, LLC, has provided Fee-Only financial advice to individuals, families and businesses since 1996. For more information, please contact us at wj@wjwealth.com or 281-634-9400.

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