Employee Stock Ownership Plans (ESOPs) offer a number of advantages for business owners, employees, and the company overall. However, some small businesses may consider themselves too small to justify the costs of transitioning to an ESOP company. A direct sale to key employees may be a way for some small companies to gain some ESOP-like advantages without using a formal ESOP.
An ESOP is a qualified retirement plan that invests primarily in employer securities. Eligible employees are provided a stock ownership interest as a benefit of working for the company. Advantages of an ESOP include the ability to maintain corporate culture while providing employer-funded retirement benefits.
Smaller companies may find it difficult to transition their company to an ESOP. There may simply not be enough employees to fund a purchase of the company. In a recent article, selling a small company to one or more select employees has been termed “ESOP Light.” However, selling your company to employees directly is not an ESOP. Even without the specific tax advantages of a formal ESOP, selling a company to employees directly does offer some of the benefits that a small business is looking for when considering a true ESOP.
Selling to employees carries a number of benefits. This includes maintaining a level of confidentiality in the business, experienced employees are already familiar with the business, and continuity is a sign of stability for customers and vendors. However, selling a small company to employees also has some drawbacks.
In a small company, employees may not have enough money to pay fair market value for the company. Without experience in business transfers and finance matters, employees may be hesitant to put their financial resources into the company. It may also take longer to transition a small company to employee ownership.
Before transferring equity in a company to a single or small group of employees, owners have to consider how transferring ownership interest can impact the business, owner, and employees. Shares of a company that are given to employees or sold at a reduced cost may be taxable compensation to the employee at the difference between the price paid and the stock's fair market value. The employer may also be required to pay payroll taxes on the compensation. However, with proper business counseling, costs and taxes can be minimized.
If the employees do not have enough cash or credit to finance the sale, the employer may have to set up a fund that will be able to purchase the company after a defined period of time. In order to avoid additional FICA and income taxes, contributions to the fund may be made through bonuses, raises, or other compensation the employee would have otherwise received. This fund can be used to purchase the company from the owner.
If you have any questions about your small business exit strategy or whether an ESOP is right for you, Butterfield Schechter LLP is here to help. We are San Diego County's largest law firm focusing its law practice on employee benefits, business, and tax law. Contact our office today with any questions on how we can help you and your business succeed.