ESOP 101

ESOP 101 - a different type of 401(k) for saving for retirement 19 Jan

ESOP 101

An ESOP is a retirement plan similar to a 401(k) plan, but with two main differences.

  1. It must invest the majority of its assets in sponsoring company stock
  2. It can borrow money to do so

ESOP 101 - a different type of 401(k)The company can make tax deductible contributions of either cash or stock to the ESOP. The plan Trustee can also purchase stock directly from shareholders, thus creating a ready market for the stock of privately held companies. Employee contributions are not required since it can be financed entirely by company contributions.

The employee accounts will grow tax free until they ultimately retire, die, or otherwise terminate their employment. The proceeds can be paid in cash or in installments, or can be rolled over to an IRA so the tax free growth can continue down to the next generation.

An ESOP is the ultimate financial planning tool, but is seldom used since business owners and their advisors do not understand the benefits. They may have heard about ESOPs but most of what they have heard is wrong. Most do not even get the name right. It is not an Employee Stock Option Plan; it is an Employee Stock Ownership Plan.

But even the name is misleading. The plan Trustee holds the stock for the benefit of the employees.

The employees do not own or vote the shares, and they certainly do not own or control the company any more than they would control General Motors if some of its stock was one of the investments in their 401(k) plan.

The sponsoring company must be a corporation. An LLC can easily be converted to comply.

Capital gains taxes can be deferred by use of an installment sale or a 1042 rollover benefit, somewhat similar to a 1031 real estate exchange. If the Qualified Replacement Property is held until death the heirs will receive a step-up in basis and the deferred capital gains liability will vanish forever.

There is no upper limit to the size of the company. Many ESOPs have over 1,000 participants, several have over 10,000, and Publix Supermarkets is perhaps the largest with over 165,000 members.

But an ESOP can be feasible for a growing company with as few as a dozen full time employees.

Since the benefits come from tax mitigation an ESOP will seldom be practical unless the company and the owner are paying more than $200,000 in income taxes annually. An ESOP is not suitable for every situation, but the benefits are so great that every successful business owner should at least consider an ESOP as one of his financial planning options.

An ESOP is not a do-it-yourself endeavor. The creation is complicated. The ESOP must conform to the laws and regulations of both ERISA and the IRS, and is overseen and regulated by the Department of Labor. Dealing with one government agency is bad enough. Dealing with three of them is horrific. The benefits are great, but the penalties for non-compliance with and violation of the rules and regulations are even greater. Companies outsource payroll, IT and HR and they should also outsource the implementation of their ESOP to experts who have created hundreds of successful ESOPs over the years.

The initial installation costs are high but will be paid for through tax savings. Yes, the initial cost to the company can be zero because Uncle Sam will provide the funds.

Learn about ESOPs at the upcoming SCORE seminar! Click here for details.

About the Author:

Harold LubbockHarold Lubbock has had an exciting 65 year career in Financial Planning and Consultation from coast to coast across Canada and the United States, and around the world. He’s been an actuary, insurance salesman, investment dealer, financial consultant, estate planner, real estate broker and business broker over the years. President of two public companies, and the CFO of a third and  a founding shareholder of two banks, and three Life Insurance Companies, and Managing Director of a Merchant Bank. Involved in the valuation, purchase and sale of hundreds of businesses, ranging from small proprietorships to multi-million dollar public companies, he’s now semi-retired and living in Arizona.


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BySCORE Phoenix

The Greater Phoenix Chapter of SCORE is a nonprofit association dedicated to educating entrepreneurs and helping small businesses start, grow, and succeed nationwide. As a resource partner with the U.S. Small Business Administration (SBA), SCORE offers mentoring for small business owners through a large network of volunteer mentors, local workshops, events, and tools.

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