Make the right decisions for you and your business.

An employee stock ownership plan (ESOP) is a type of retirement plan—a tax-qualified deferred compensation plan formed as a trust, to be exact—that allows you to transition the ownership of your business (in the form of stock) to your employees.

An ESOP is its own entity and must file tax returns (Form 5500) to report activity and provide information, but it doesn’t pay tax. Instead, the filings are used to track basis for employees. Like any qualified plan, an ESOP must comply with all applicable IRS and Department of Labor (DOL) rules. Typically, ESOPs are subject to an annual financial statement review or audit, as well as a valuation.  The company owned by the ESOP must also continue to file tax returns. The effect an ESOP has on your company’s taxes will depend on your company’s entity type.

An ESOP can serve as a valuable benefit to your employees while also providing a means of selling your business. But transitioning to an ESOP isn’t a viable option for every business. There are several factors to consider,  including items ranging from your financial needs and number of employees to your company’s profitability.

What Are the Pros of Transitioning to an ESOP?

There are several advantages of transitioning to an ESOP, the most obvious of which is that it’s a meaningful way to give back to employees. An ESOP also allows your business to defer income tax payments, the cost savings from which can be used toward revenue-generating initiatives such as expansion. What’s more, an ESOP can help you attract and retain top talent by giving employees an opportunity to share in company growth on a tax-deferred basis. It can serve as a powerful incentive for loyalty, too—the longer an employee stays with your business, the more his or her stock value will increase.

Is an ESOP Right for You?

If your goal is to maximize your return on the sale of your business, an ESOP likely won’t help you get there. Transitioning your business to an ESOP will typically net fewer proceeds than if you were to sell to a third party (without a broker). It’s likely there will also be more costs associated with becoming an ESOP than with a third-party sale. This is partly because a successful ESOP transition requires the services of several professionals.

To complete an ESOP transaction, you’ll need two teams of professionals: one representing you, and the other representing the ESOP. The professionals you will need include a CPA; an attorney for your business, the ESOP, and you; a trustee; and a valuation company. Because you, as the business owner, are paying for both teams, an ESOP often becomes more expensive than other sale transactions.

If your business has a high employee turnover rate, an ESOP may not be the right choice. Employee continuity is important for a successful ESOP. Without consistent employee numbers and leadership, an ESOP may not be a good fit.

How to Prepare for an ESOP Transition

If you’re considering an ESOP, it’s important to start preparing for it as soon as possible. A good first step is to explore ways to strengthen your management team. Having a strong team in place—before you establish your ESOP—will make the whole process go much more smoothly and likely increase your sale price.

In most cases, a business will need a valuation before it can become an ESOP. Since valuators typically use both projected and historical financial information to determine a company’s value, consider laying the financial groundwork needed for the transaction as soon as possible.

Here are two things you can do right now:

  • Consider obtaining financial statements issued by an accounting firm. We recommend starting with a compilation or review. The valuation company will review past years’ company financials (typically the past five years) as part of the valuation process. In addition to an increased level of comfort, having issued financial statements allows you to address any inconsistencies with generally accepted accounting principles (GAAP) your accounting may have. Issued financial statements can also give you a clearer picture of your company’s performance, empowering you to make more informed business decisions.
  • Another component of the valuation process is a review of management’s projections. Generally, the valuation company will request projections for the next five years. Since these types of projections are also good business practice, why not start a formal process for them now?

How JAK + Co. Can Help

As in any business transition, there are many structures and methods to consider in order to accomplish your goals.

Regardless of where you are in the ESOP process, we’re here to help you explore your options and think through pros, cons, and tax implications. When you’re ready, we can recommend industry experts who would be a good fit for one of your professional teams needed for the transaction. We can also assist in preparing the financial information you will need, discussing your goals, and recommending possible structures for the transaction. Throughout the process, we’ll be at your side, helping you seamlessly communicate with everyone involved.

Our ESOP advisory and accounting services include:

Explore Your ESOP Options

As your ESOP advisor, the JAK + Co. team can help you be creative when it comes to ESOP agreement structures. We can support you throughout the process, from connecting you to trusted resources to providing taxation expertise. We can also advise you in the valuation process, providing a “ballpark value” to help you better understand your options. We’re happy to sit down with you anytime to discuss if an ESOP is right for your business. If you’d like to learn more about your ESOP options, contact us today.

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