Michael Savoy, Gumbiner Savett’s Managing Director, recently wrote an article about the affordability of ESOPS in today’s economy.  Michael knows this area well and has often spoken for the California Society of CPAs’ Educational Foundation on succession planning and exit strategies with an emphasis on ESOPs.

ESOPS More Affordable in the Current Economy  

The employee stock ownership plan (ESOP) is hardly a new concept, but it seems to be catching on with small and midsize business owners lately. The number of ESOPs have been steadily rising to 11,500 in early 2011 (10% of the private sector workforce) from roughly 10,600 in 2007, according to a study by the National Center for Employee Ownership.

What’s the story behind this uptick? One possible answer is, believe it not, the rough economy. Lower profits mean lower values on company shares, which, in turn, have made ESOPs a bit more affordable. To help you decide whether now may be a good time for your company to “pop” for an ESOP, let’s take a closer look at these arrangements.

The basics

An ESOP is a form of qualified retirement plan, specifically a profit-sharing plan. The primary distinguishing feature of these arrangements is that they essentially allow employees to own part of the company that employs them through the ESOP and then cash in their shares when they retire or otherwise leave the business.

Generally, an employer creates an ESOP by setting up a trust and contributing new company shares to it. Cash contributions, which can then be used to buy shares from existing owners, are also generally permissible. The trust becomes the legally recognized owner of the company shares and is managed by a trustee that oversees the employees’ interests. The trustee is most often appointed by the company’s board of directors (or another upper-management body). Once it’s up and running, the ESOP receives annual, tax-deductible contributions from the company that fund participants’ retirement accounts.

Typically, there are two types of ESOPs. An unleveraged one receives either contributions of stock or cash contributions used to buy new or existing shares of the company’s stock. In other cases, a leveraged ESOP borrows money from a financial institution and uses the loan to buy new or existing shares. The business then contributes cash to the plan to repay principal and interest on the loan over a period of years.

Tax benefits

ESOPs have several advantages, including increased employee motivation and ease of ownership transition. But the immediate tax benefits are worth considering as well.

Deferred Gains: For ESOPs that buy out at least 30% of a closely held C corporation, selling owners may defer their gains indefinitely by reinvesting the proceeds in qualified replacement property (most securities issued by domestic operating companies will qualify) within one year after the sale. Doing so gives them an advantage over an outright sale.

Deductions: With leveraged ESOPs, the business can deduct contributions used to pay the interest and the principal on loans used to acquire the stock. And if the company is a C corporation, it may be able to deduct certain dividends paid on ESOP shares. In addition, interest payments don’t count against contribution limits.

If your company is structured as an S corporation with multiple shareholders, you can set up an ESOP. But the tax benefits are more limited: You can’t defer gains or deduct dividends, and interest payments on loans from leveraged ESOPs do apply toward the contribution limits.

Read more of the article and about  rules for distributions of ESOPS and the importance of valuations in our “GS Documents” section.