"Properly structured, an ESOP can delay capital gains taxes and minimize estate taxes," says Phil Harriman, a financial adviser in Falmouth, Maine.
The plans are especially good for owners who don't need the cash right away. And if certain conditions are met, an owner who sells stock of a C corporation to an ESOP may defer or completely avoid paying capital gains on the sale.
Also, when an S corporation sells 100% of its stock to an ESOP, it becomes a tax-free entity for federal income tax purposes, thereby increasing the cash flow in the business. That's particularly appealing right now with tax rates expected to increase and many business owners unable to find acceptable buyers.
There are drawbacks, Harriman warns. Setting up an ESOP could cost $50,000 to $100,000 because the company needs to, among other things, be appraised and name trustees for the ESOP. There also are ongoing costs, because the company needs to be appraised annually and the ESOP managed.
It's thus crucial for the business to have reasonable expectations of profitability and growth going forward. The ESOP needs to be able to pay its expenses and loans and repurchase stock from employees when they leave or retire.
Jeff Gilbert, president and CEO of Software Engineering Professionals Inc., in Carmel, Ind., decided to sell the business to an ESOP after one of his partners died last year.
"I just wanted to have the option to do something else if I chose to," he says. "This gives me flexibility to move someone into my job in the next five to six years."
He is partially financing the sale with a note. As long as the company keeps earning, this type of arrangement can provide the owner with about a 6% return until the note is repaid, according to advisers.
The ESOP gives workers an incentive to help the company grow and can bring rewards when they retire. It isn't unusual, according to advisers, for even lower-paid long-term workers to receive hundreds of thousands of dollars at retirement because of the assets they've acquired in the ESOP.
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