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What is An ESOP and How Can It Help Fund my Retirement?

April 03, 2015

Employee Stock Ownership Plans (ESOPs) are a tax-deductible savings plan that could provide substantial benefits for your ultimate retirement plans.

If you are one of the many business owners that has a large portion of your wealth bound to your company, there may be a way you can convert part of that wealth into cash to fund your retirement. Similar to a profit sharing or 401(k) plan, an Employee Stock Ownership Plan (ESOP) is a qualified retirement plan used by many owners of corporations to generate liquidity and ownership succession.

How does an ESOP work compared to other plans?

In contrast to other retirement plans, an ESOP invests chiefly in the employer’s own stock, rather than in a mixture of stocks, mutual funds, and bonds. In addition to this, ESOPS are:
Tax Deductible- The business owner makes contributions to the ESOP which are tax deductible, and the plan uses these contributions to procure stock from the company or its owners. Hence in establishing an ESOP, you are creating a buyer for your shares. By doing this, you have a chance to motivate employees who gain the opportunity to share in the company’s growth, through participation in the ESOP, without a current tax burden. Employees can receive stock or cash benefits when they retire, too.

Strictly regulated- Similar to other qualified plans ESOPs are regulated fairly strictly. They are subject to annual contribution limits, typically 25% of covered compensation, and to qualify for an ESOP, you must be a full time employee with certain age and service requirements.

Certain rules apply to ESOPs that don’t apply to other retirement plans. When the ESOP is established and annually from then on, business owners must gain an independent appraisal of the company’s stock. ESOP participants who receive stock distributions must be provided the right to sell their shares back to the company for fair market value. This is something that companies must consider before committing to an ESOP, as it creates a repurchase liability.

ESOP benefits

  • Defer the gain on the sale of your shares. You are able to defer the gain on the sale of your shares indefinitely (if the ESOP acquires 30% or more of your company) by reinvesting the earnings in qualified replacement property (generally publicly traded securities) within one year following the sale.
  • Finance the buyout with borrowed funds. A “leveraged” ESOP basically allows your business to subtract the interest and principal on loans used to make ESOP contributions. Certain dividends paid on ESOP shares can be deducted as well. Contribution limits are not affected by interest and dividend payments.
  • Cash out without relinquishing control. Sales and other exit strategies often require you to hand over control in exchange for cash, but not ESOPs! ESOPs allow you to cash out without surrendering any control.

If you wish to exit from your corporation, an ESOP can provide substantial benefits and advantages. Being that ESOPs are very technical by nature, it is wise to seek guidance from tax, legal, and employee benefit advisors.

Questions? Contact any member of our Tax Services Team.

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