As a small-business owner in a creative field, you rely a great deal on a core group of employees that share in project responsibility and success. These employees have developed a marketable skill set under your guidance that you and your customers value. You treat them well in return for their loyalty and skill set, but with growing value placed on those skills, you may be thinking more about ways to retain them.
An Employee Stock Ownership Plan (ESOP) is an attractive mechanism to create more loyal and vested employees, as well as to reap financial rewards from the company that you’ve created. Architecture and engineering (A&E) firms are culturally aligned to become employee-owned companies as illustrated by the National Center for Employee Ownership (NCEO) listing of America’s largest majority employee-owned companies. There are a number of notable firms on this list, including CH2M Hill, the top firm in terms of size. CH2M Hill has gone so far as to have an internal stock market. The company points out the benefits of employee ownership on its website, stating that customers “get the best of both worlds: the entrepreneurial spirit and personal attention of a small company combined with the long-term stability, experts, and technologies of a large corporation.”
Timing and Benefits
While there are tangible benefits for employee loyalty, companies of 15 or more employees (with one or more owners who wants to sell), are the most likely to become employee-owned.
“An ESOP comes about largely when a company has owners who are at a certain stage in their lives when they are ready to sell to gain some liquidity,” says Corey Rosen, founder of NCEO. “If there is more than one owner, the other owners can buy them out, but that’s expensive. You have to make the money, and then pay taxes, and then buy them out with what’s left over.”
Putting the company up for sale is another route, but oftentimes the owners want to see their legacy continue and may want to continue working at the company. Selling the company is a sharper break than selling their equity because a sale to another owner holds no guarantees regarding the future of the company and the company’s employees.
“Going to an ESOP is both emotionally appealing to a lot of owners, but it’s also financially appealing,” Rosen says.
An ESOP is a qualified employee retirement plan similar to a 401(k). Like a 401(k), the stocks are a trust that the employer sets up, but the employees don’t fund it with their own investments. The employer invests profits into the ESOP, takes a tax deduction for that investment, and uses the money to reward employees and buy out owners.
“If you want to buy out an owner quickly, which is often the case, then the ESOP can borrow money,” Rosen explains. “It can borrow money from a bank, it can take a note from the seller, if the company has cash you can borrow it from the company.”
If a seller wants to liquidate $2 million in stock, the ESOP borrows $2 million to buy that value in stock, which goes into something like a bank account within the ESOP. As the loan gets repaid, the shares get allocated to the employees based on a relative pay or another formula. It is broad-based, meaning you can’t be discriminatory by picking which employees become owners.
If the company bought back the borrowed money directly, it would have to pay taxes on it, and the $2 million would cost roughly $3.5 million. With this arrangement, the $2 million costs $2 million without the taxes, which is a huge savings. This can be done for any percentage of the company up to 100 percent.
Taxes and the Corporate Form
The corporate form (whether you are an S Corp, C Corp, LLC or other) matters in terms of what plan you use, but any corporate form (other than partnership or proprietorship) has some options.
In a C Corp, where the owner gets bought out and the shares are equal to or greater than 30 percent of the company, they can invest in other things and not pay taxes until they sell those other things.
In an S Corp, these deferred tax benefits don’t apply. An S Corp is what’s called a pass-through entity, where the company doesn’t pay any tax—the owners do. If an ESOP owns 30 percent of the company, it owes taxes on that share of the profit, but its tax rate is zero. It’s the only non-taxable entity by design, which means 30 percent of the profits aren’t taxable. If the ESOP owns 100 percent of the company, which is true of a growing number of large A&E firms, then it is not required to pay any taxes.
If you own a limited liability company (LLC), you can’t have an ESOP, but you can give employees stock options, shares, rights to buy shares at a fixed price at some point in the future, or restricted shares that require employees to work a certain number of years before they can have them. With this mechanism, you can give the award, and taxes need not be paid on it until they appreciate and the interests are sold, at which time capital gains tax rates would apply. Employees must hold the interests for at least two years, and the award can’t be pegged to a specific stream of income as in more conventional profit-sharing plans.
There is a fair degree of complexity with the various profit-sharing and employee-ownership mechanisms, with different tax benefits and varying administrative burdens. Given the complexity, this decision comes with the need for some research, as well as a trip to a corporate lawyer to fine-tune the details and draft the required paperwork.
“I would caution a company owner to not go to his or her regular lawyer because you’ll get whatever hammer they happen to have,” Rosen says. “They may not know about all your options, and it’s a good idea to become educated rather than go to a lawyer first. That way you can explore the various plans and have an idea about what kind of plan will make the most sense for you.”
There are certainly downsides to shared ownership, with the most obvious being a cut in equity where you no longer hold the full benefits of your success. However, none of these plans alter corporate governance, so you still retain control and are able to receive reward while also rewarding valued employees.
For more small-business tax tips, check out Capex Vs. Opex: 5 Tax Considerations to Keep Your Small Business Strong and 4 Small-Business Tax Tips for 2013.