United States: ESOP Light: A Creative Succession Strategy For The Small Business

Last Updated: February 2 2017
Article by Harvey M. Katz

In reality, ESOP "light" is not an employee stock ownership plan (ESOP) at all. It is a way of structuring a retirement plan to provide many of the benefits of an ESOP, while avoiding all of the complexities and costs of implementing an ESOP. It is designed to address the needs of the retiring owner of a small business that is too small to implement an ESOP in a costeffective manner and has limited third-party suitors for the business.

The most viable business succession option for many of these small businesses is to sell to one or more key employees who have been instrumental to the success of the business or who have been hired with the promise and/or expectation of earning an equity position through their efforts. Aside from the possibility that the key employee may decide to seek greener pastures, the problem with this strategy is that many do not have the funds to purchase any significant portion of the business. Most expect to be "awarded" the shares in exchange for their past and future efforts.

Even in those cases in which the current business owner is willing to transfer the shares to the employee for nominal (or no) consideration, there is a flaw in this strategy that is often overlooked. Simply stated, equity transferred to any individual in a compensation environment, (i.e. to an employee or independent contractor) is taxable, ordinary compensation income to that employee. In other words, the employee will be liable for federal, state and local income tax on the fair market value of the shares transferred even when little to no value is paid. Additionally, the amount is subject to FICA taxation and both the employer and employee must pay their respective shares of that tax. Many employees also expect to receive a bonus or loan from the employer to enable him or her to pay their share of the tax.

The solution is to create a fund to provide dollars to the business owner that becomes the source of funds to serve as the equivalent of an ESOP. A specific kind of a defined benefit or cash balance plan will serve that purpose. Unlike an ESOP that purchases the shares from the owner, the defined benefit plan will simply provide additional dollars to the owner, which can be rolled into an IRA. However, defined benefit plans and cash balance plans are not a new concept, and a natural question is: what makes this idea different? The answer lies with the design of the plan, the source of the funds contributed and the use of those same funds.

The typical design of a pension plan in a closely-held corporation is to maximize contributions for all of the key employees, including the owner, while minimizing contributions for rank and file employees. Inclusion of all key employees in the "favored" class of employees increases the cost of the plan and increases the difficulty of passing IRS discrimination rules, which require a certain level of benefits for rank and file employees. In the case of an ESOP "light," the goal of the pension plan is to favor only the owner. Other key employees are excluded from the plan by design. In other words, the plan is designed to favor only the owner and minimize benefits for all others. In doing so, the plan and its assets can be used for the primary purpose of "buying out" the owner's interest in the company.

The source of funds to fund the plan is also critical to the plan design. Undoubtedly, part of the source will come from dollars that otherwise would have otherwise been paid to the owner as additional salary or profits distribution. However, an essential element of the plan design is that the other key employees fund the plan by foregoing what would otherwise be paid to them in raises, bonuses and other forms of incentive compensation during the period it takes to fund the plan. In essence, the other key employees are "paying" for their interest in the company by foregoing a portion of their compensation during this period. At the end of the pre-defined period (usually around five years), the owner will sell the shares to the employee for a relatively modest price, retire from the company and take his pension from the plan. Another advantage to using this strategy is that the benefit can be paid to the owner in a lump sum, rolled directly into an IRA and is not taxed to the owner until withdrawn.

Of course most key employees will be reluctant to "buy-in" to this concept unless they are protected with an agreement that gives them the right to purchase the company – at the right price – after the plan is funded. While this agreement should be protective of the key employee, it is important to note that in the event of a subsequent "falling out" between the owner and any key employee, the funds contributed to the plan cannot be disturbed and the owner will be in an advantageous position.

There are other challenges and issues that may arise in the context of designing an arrangement like this, many of which go beyond the scope of this article. However, the ESOP "light" concept clearly represents an alternative method to compensate an owner for the value of the small business when the traditional ESOP option may not be available.

The content of this article is intended to provide a general guide to the subject matter. Specialist advice should be sought about your specific circumstances.

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Harvey M. Katz
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