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Benefits Take A Turn With Stock Options
An often overlooked alternative in retirement planning is the Employee Stock Ownership Plan (ESOP). Changes in the Internal Revenue Code will allow S Corporations (corporations with a maximum of 75 stockholders) to adopt an ESOP. This will allow the corporation the chance to provide its employees with direct ownership opportunities. That, in turn, will encourage employee motivation and retention.
“The psychology behind the ESOP is when employees have a piece of the pie they are willing to work harder. In turn when the employees work harder the company will increase profits, therefore stock will increase and so will each employees account,” said Mark Lachowicz, senior consultant of Plante & Moran’s Employee Benefit Consulting Group.
There are certain corporations for which an ESOP will work better than others. When deciding whether or not to utilize an ESOP, a corporation should determine if it has the following: good cash flow; a strong management team; and a history of consistent earnings. If so, then an ESOP may be the right decision.
“However,” said Joe Rankin of Plante & Moran’s Employee Benefit Consulting Group, “each corporation that decides to take this course of action should carefully consider all the facts involved.”
The business situation should be analyzed in a feasibility study to see if an ESOP makes sense, said Lachowicz.
“We have to see what we are dealing with. For example, is this a situation where the owner is looking for an exit strategy? Are we looking at a situation where there is an interest in sharing the company? This process can go a long way.”
The advantages of an ESOP are in the tax issues and amounts. When stock is contributed to an ESOP, a portion of the corporation’s income escapes current tax. This can provide additional cash flow for the corporation and with that the corporation can reinvest in operations, pay off debt or distribute it to shareholders.
Eventually, taxation will occur when participants take distributions from the plan. In addition to this advantage, an ESOP can also be used as an exit strategy or succession plan when an owner cannot find a buyer or there are no family members to continue the business.
Contributions made to an ESOP by an employer are completely tax deductible.
“This is one area of the ESOP that makes it so attractive to businesses. Unlike a loan where a business can only deduct the interest, the entire contribution made is tax deductible,” said Lachowicz.
The key to an ESOP, Lachowicz said, is to having a leveraged ESOP, one that incurs some debt.
“The company then makes a contribution, just like a retirement contribution, to the ESOP,” he added. “The ESOP then gets the cash and the proceeds are then forwarded to pay off the debt.”
It can also provide some estate tax planning liquidity when the taxpayer’s main asset is in stock with the corporation.
“The ESOP is set up for the primary purpose of investing in company stock. If we are dealing with a business owner who has been successful in the business area but when it comes to personal wealth the only asset is the company, something must be done,” noted Lachowicz. “As the business owner gets closer and closer to retirement he will want to diversify his investment portfolio. In this situation we can use the ESOP to buy stock from the owner and use the cash from the sale to purchase other investments.
“The most attractive points of ESOPs are that there are so many different ways of structuring ESOPs. That way they are adaptable to almost any business strategy.”