Figuring out how many shares to sell to the ESOP is a fundamental decision part of the planning process. In the final installment of our 4-part series, we look at some of the factors in play when making that calculation. In Part 1 we look at ESOP Basics. Part 2 discusses how to determine if an ESOP is right for you and your company. Part 3 looks at ESOP’s tax benefits.
How Many Shares Depends On Your Goals
Owners are often surprised that the decision-making process involved in determining how many shares to sell to the ESOP helps clarify short- and long-term goals for both themselves and their companies. A number of factors help determine how many shares to sell and how many shares the ESOP can prudently buy. For example:
- How much financing is available and at what cost?
- Does the owner/seller want or need to receive a certain percentage of the purchase price in cash?
- Is maximizing the income tax deduction a priority? If so, how large a deduction can payroll support given the deduction limits?
- Does the owner want to continue owning shares and, if so, how many? A majority?
Answering these questions will be a big help when deciding how many shares will be sold to the ESOP.
Tax Rules Can Help Guide ESOP Planning
From a tax perspective, the ideal ESOP design for an S corporation is being 100% ESOP-owned. In this design, 100% of the company’s income is passed, tax-free, to the ESOP. However, if maximizing deductions is a priority, the deduction limits for S corporation ESOPs may mean this “perfect” tax ESOP design is not be the best vehicle. This design also won’t work for an owner who wants to continue owning shares or defer tax on the sale proceeds. If these and other factors are important, then the “perfect” number of shares in the ESOP may be something less than 100%.
For C corporations, the “perfect” vehicle may be an ESOP that owns more than 30% but less than 100% of the corporation’s outstanding shares. It would let the owner defer income taxes on the proceeds of the sale while still retaining direct ownership of a desired number of shares.
For both C corporations and S corporations that are less than 100% ESOP owned, the number of shares sold to the ESOP may depend on whether the company’s payroll can support a full deduction for the value of those shares.
How Much Of The Owner’s Stake Is Coming Off The Table?
The owner’s desire of whether to immediately cash out of their investment in the company or do so over time will also be a major factor in how many shares are sold to the ESOP. The owner may initially want to remain a majority shareholder but may later decide that she wants to sell her remaining shares to the ESOP as she nears retirement. In this example, the ESOP is initially designed solely to provide a benefit to employees, but with a view to the ESOP gradually becoming an exit strategy for the owner as well.
No matter how many shares the ESOP ends up owning, remember that you can create a design flexible enough to benefit the corporation, employees and shareholders throughout the life of the ESOP, while preserving the owner’s options for the future.
What Financing Is Available?
Available financing for the ESOP transaction can also impact an owner’s decision of how much stock to sell to the plan. All-cash stock sales are rare because most buyers require at least some financing. That’s why it’s easy to consider an ESOP as an alternative to a third-party sale. If an ESOP is the buyer, not only is there a ready-made market for the shares, but the purchase price can be paid with pre-tax money because the company can deduct contributions to the ESOP. Congress intended this favorable tax treatment to encourage owners to consider their employees as a great option for selling a closely held business.
ESOP purchases can be financed by an outside lender or by the seller, just as any other third-party sale. They can also be financed as a loan from the company to the ESOP at a favorable interest rate. As of April 1, 2019, qualifying small-businesses eligible for an SBA loan can use the loan proceeds to cover the purchase price and some or all of the ESOP transaction expenses.
A company loan even creates a deduction for the company when contributions to the ESOP are used to make payments on the loan. If the seller doesn’t want to take a promissory note, then the number of shares to be sold to the ESOP will be limited by the amount of cash the company can raise – either existing cash in the company, cash borrowed from a lender, or some combination. This seller can postpone selling additional shares to the ESOP until the company has rebuilt its cash reserves or has more borrowing capacity.
The transaction can also be structured to include a cash payment at closing sufficient to cover the selling owner’s tax liability with the remainder of the purchase price financed over a number of years. Alternately, the seller can choose to recognize gain on payments as they are made over time.
The financing must be flexible enough to satisfy the needs of the selling owner while allowing the ESOP to support the loan payments made from cash contributions by the company.
Additional Resources
You’ll find concise answers to almost any possible question you might have about ESOPs in our Employee Stock Ownership Plan Video FAQs.
