Many small business owners approach succession planning and retirement planning hungry for the fastest, simplest, and most immediately lucrative solution possible — a quick sale, often to private equity or other external buyers.
At Iron Point Financial, we get how that route could seem enticing, especially from a short-term perspective, but what if there were another, more sustainable and satisfying pathway — one that met your need for a payout at market value, sidestepped a huge potential tax burden, and set your company up well for years to come, long after you have moved on?
If you’re a small business owner considering your next chapter, an Employee Stock Ownership Plan (ESOP) could be the effective, tax-efficient answer you’re looking for. As we explain throughout the rest of this blog post, ESOPs could offer a sustainable, mutually beneficial way forward for you, your company, and your employees — one that both honors your existing company culture and values and supports its profitability for the long-term…
Aesop’s Fables or Fabulous ESOP Tax Benefits?
If you are anything like us, you probably sounded out “ESOP” in your mind when you read it on this page. You might also have noticed that this four-letter acronym sounds almost exactly like Aesop, the legendary Greek fabulist from 2,500 years ago, whose stories still educate and inspire people across the world today.
That might seem like a bit of a random connection to make, but as we have thought about the potential benefits of ESOPs for business owners, it occurred to us that there could be a great poetic analogy between one of Aesop’s most renowned fables and ESOPs the succession planning tool — specifically, the iconic fable of The Tortoise and the Hare.
As we’re sure you know, the moral of that particular story was (say it with us), “Slow and steady wins the race.” In other words, the quickest path may not always be the most effective, and there can often be immense value in a more persevering, big-picture approach. In the corporate retirement planning world, that’s exactly the kind of ideal ESOPs represent.
Unlike rapid business sales (‘the hare’), which can result in costly disruptions to company culture, employee morale, and long-term business viability — e.g. through large-scale layoffs, moving factories abroad, and introducing practices alien to current employees — ESOPs can instead facilitate a healthy ownership mindset among employees because, through ESOPs, they actually become part-owners.
This kind of alignment can encourage productivity, loyalty, and wholehearted commitment to your company’s long-term success — much like the methodical, intentional, and ultimately victorious tortoise in the story. It could also be a great way to secure your legacy (the impact you have left on the world and your community) for generations to come, in fact, not fiction.
But those aren’t the only advantages ESOPs have over other succession planning options…
ESOP Tax Benefits for Small Business Owners
Perhaps the most compelling financial selling points ESOPs have to offer small business owners and other stakeholders relate to the significant tax benefits afforded under current US law:
- Tax Deferral on Sale Proceeds
One of the most appealing ESOP tax benefits is the ability to defer your capital gains taxes through a Section 1042 rollover. Provided that you have owned the company shares you are selling for at least three years, your company is a C Corp, and the ESOP you set up gains ownership of at least 30% of your company’s total stock at the time of sale, you may reinvest the proceeds from the sale into qualified securities, effectively deferring capital gains taxes indefinitely.
Hypothetical Example: Imagine you’re a small business owner selling your company, which is valued at $5 million. Without an ESOP in place, you would face substantial immediate taxation, potentially losing upwards of 20% in federal capital gains taxes (for our purposes, approximately $1 million). However, by using an ESOP and reinvesting your proceeds wisely, you could defer that entire capital gains liability, retaining more money upfront to invest or generate ongoing income in your retirement years.
- Tax Deductibility of Contributions:
Contributions made to the ESOP to repay loans are tax-deductible under US law, significantly reducing your company’s taxable income and increasing your available cash flow.
Hypothetical Example: For example, if your company borrows $2 million to fund an ESOP purchase at an interest rate of 5%, the company would pay approximately $100,000 in interest annually. Because this interest payment is tax-deductible, if your business is in a 25% tax bracket, you’d save $25,000 each year on taxes. Over a 10-year loan term, that would be a total of $250,000 in tax savings, in addition to the capital gains tax deferral you benefitted from in the original sale.
- Tax-Exempt Status for S Corporation ESOPs
If your company operates as an S Corporation and is fully owned by an ESOP, your business’s profits become effectively tax-exempt. This arrangement could free up substantial cash reserves, which can be reinvested back into the business, benefiting both employees and owners.
Beyond Tax Savings: Additional ESOP Benefits
While ESOP tax advantages are considerable in their own right, the benefits don’t have to stop there. Additional ESOP advantages for small business owners and employees typically include:
- Preservation of Company Culture: Selling to an ESOP can help to ensure that the company’s culture, vision, and values remain intact, as ownership stays in the hands of employees who already understand and embody these principles.
- Employee Engagement and Retention: Employees who share in company ownership are more likely to stay loyal and engaged, as they get to benefit directly from the company’s ongoing success, in turn facilitating an environment of teamwork, motivation, and low turnover.
- Enhanced Business Stability: ESOP companies have demonstrated greater stability, resilience, and long-term profitability, which is good news for any small business owners concerned about the future of their legacy once they leave.
A Founder’s Perspective
As a small business, we know how important company culture, employee engagement, and business stability can be. Greg Liszka (CFP®, RICP®), President & Advisor at Iron Point Financial puts it like this:
“Culture always comes down from the top. It’s been my experience that if you can lead from the front and by example, then you will develop a meaningful culture.
If you are the same person in front of your clients or customers as you are to your employees, then that vibe carries through. I see it as my job to make sure that my staff have the tools and the direction they need to be successful. I want to create an environment where they smile.”
If it’s true that culture comes from the top, ESOPs, perhaps more than any other succession planning vehicle, can help to ensure continuity. This is because, after an ESOP is successfully implemented, the new “top” is the people who already know and contribute to your existing culture — people you have been working alongside for years if not decades. Through the ESOP, these same people now have the opportunity to become owners.
Is Your Business a Good Candidate for an ESOP?
Not so fast! Let’s stick with our tortoise-inspired theme to issue an important PSA: not every organization is an ideal candidate for an ESOP. As we alluded to earlier, some of the best ESOP tax benefits come when your company is a C or S corporation, but other key factors indicating whether your company could benefit from ESOP succession planning include:
- Stable and Predictable Cash Flow: Consistent profitability is crucial since ESOPs often involve borrowing funds to purchase shares (i.e. being approved for bank financing), as well as predictable cash flow to assure your company’s lender of repayment.
- Strong Leadership Team: Having a capable management team that can smoothly take over operational leadership can help to ensure that the business keeps thriving after the transition.
- Employee-Focused Culture: Companies with a strong culture of employee engagement and loyalty often realize the greatest ESOP success, leveraging the new employee ownership dimension to further drive motivation and productivity.
- Long-Term Vision: Owners who prioritize the long-term success of their company and employees over short-term financial gain are excellent ESOP candidates, aligning, on a core level, with the ESOP model’s rationale.
Explore ESOPs with Iron Point Financial Today
Thinking through succession planning options and exploring retirement planning strategies can feel overwhelming, but you don’t have to do it alone. At Iron Point Financial, our experienced advisors are here to help you understand whether an ESOP aligns with your financial goals, company culture, and long-term vision.
You might not have considered ESOPs before but, as Greg Liszka (CFP®, RICP®), President & Advisor at Iron Point Financial explains,
“We try to do it a little different. Your typical advisor — a lot of the people out there — doesn’t want to think outside the box. They’ll just tell you: “Buy this mutual fund.” Everybody gets the same thing. That’s what we fight against with every part of our being. There are so many avenues out there that just take a lot more research and time to understand, once you can grasp them.”
ESOPs are exactly that: an avenue that takes time and research to understand, but which can provide huge financial, cultural and tax benefits for the business owners and employees who choose them.
So if you’re a small business owner looking for sustainable succession planning solutions, why not reach out to Iron Point Financial today to explore whether an ESOP could be the right option for your exit planning needs?
Iron Point Financial is here to empower you to secure a brighter tomorrow. We operate physical offices in Grove City, PA and Greenville, PA.
We primarily serve residents of Pennsylvania, Ohio, West Virginia and Florida but we also have security registrations for 22 other states across the continental USA.
