Aesop's fables are great stories, but they aren't true. Read on to discover a great “ESOP” story with an exciting lesson that may be true for you.
As dealers look at exit strategies, large tax liabilities are frequently encountered in a stock sale or an asset sale followed by liquidation. A method that defers or eliminates tax is always of interest. A sale of dealership stock (particularly of a C Corporation) to an ESOP may be such an alternative in the right situation.
What's an ESOP? It's an Employee Stock Ownership Plan, created under the Internal Revenue Code. It's basically a special type of qualified employee retirement plan. What distinguishes an ESOP from other retirement plans is that it invests primarily in the common stock of the employer corporation (i.e., the dealership).
Of course, to invest in dealership stock the ESOP must acquire it from the current shareholders. To do so, ESOPs can borrow money which is then repaid by cash contributions made by the dealership corporation. The ESOP becomes a shareholder in the dealership.
An ESOP may borrow from the corporation, shareholders or any third-party lender.
An ESOP loan must meet certain criteria. For example it must be primarily for the benefit of the participants, must have a reasonable rate of interest, be used to acquire employer securities, be repaid from employer contributions, have a specific term, and meet certain rules that apply with respect to security interests.
The proceeds of a loan are used to buy a block of stock from the dealer or other shareholder. The selling shareholder can qualify for great tax advantages to be discussed later. To pay off the ESOP loan, funds come from the dealership corporation in the form of deductible contributions. In effect, the loan principal repayments are deducted for tax purposes by the dealership.
The dealer or other shareholder, who received the ESOP loan proceeds in payment for some of his stock, is able to take advantage of certain tax benefits. Normally when dealership stock is sold, the gain is taxable. This is not necessarily the case when stock is sold to an ESOP. Gain can be deferred or even eliminated in some cases.
The stock owned by the ESOP is allocated to the accounts of the participants (i.e., the employees of the dealership). Allocation is made only to the extent that the value of the stock exceeds the debt of the ESOP. Stock on which gain has been deferred may not be allocated to the account of the selling shareholder or a member of his family for a 10-year period.
When employee participants retire or leave the company, their vested interest in the stock of the company may be paid to them in cash or in stock. In the case of stock that isn't publicly traded, the ESOP must give the employee the option to sell the stock to the ESOP at fair market value.
Aside from the tax benefits, another reason to consider an ESOP is to provide an employee benefit or incentive. Through the ESOP the employees become owners in the company. This should lead to greater dedication, increased effort and reduced turnover. The bottom line should benefit.
ESOPs are complex and not for everyone. In the right situation however the benefits may be worthwhile. While ESOPs may be a compelling story, they are certainly not a fable.
Don Ray is a Senior Member of the George B. Jones Dealer Services division of Dixon Odom PLLC, a national accounting and consulting group for automobile dealers. He's at 901-684-5643