Basic ESOP Question: How does the owner benefit each year when the company contributes to the retirement plan?

[Guest lwbarry]

Hi everyone,

I'm a financial planning master's student with a ESOP question.

I understand the tax advantages to the owner and the company of setting up an ESOP. What I'm wondering is: How does the owner benefit financially each year when the company makes its contribution to the ESOP?

A bit more detail: I'm working on a final project for an employee benefits class. Our hypothetical company wants to establish a qualified retirement plan and contribute $190,000 this year. The owner has a retirement savings need of $560,000 in 16 years, in addition to his other resources. I'm supposed to recommend a qualified retirement plan and explain how it will help the owner meet his retirement savings need.

So with a straight profit sharing plan, he would get $X (his portion of the $190,000) a year, and I would need to calculate whether that $X a year would grow into $560,000 in 16 years.

But with an ESOP, is he actually getting anything each year when the company contributes to the plan?

Thanks--I can post more details if necessary.

Leonard Barry

Madison, WI

[RLL]

Hi Leonard ---

If the owner is interested in sharing ownership with the other employees, an ESOP should be considered. If the owner is interested in selling all or a portion of his company stock to an ESOP for the benefit of the other employees, an ESOP should be considered.

But if neither of these is an objective of the owner, and if the major purpose of the qualified retirement is to fund the owner's personal retirement savings, an ESOP is certainly not the best choice for a company retirement plan.

[Guest lwbarry]

Hi RLL,

Good question--the owner does want to share ownership. I'm trying to figure out how the owner benefits each year in an ESOP.

For example, in my hypothetical situation, if the company had a profit sharing plan that allocated the employer contribution according to compensation, the owner would get ~$21,000 of this year's $190,000 employer contribution. I can show that ~$21,000/year will grow to $560,000 in 16 years assuming a certain rate of return.

But with an ESOP, what does the owner "get" each year? He/she already owns the business, so stock doesn't really help (or does it?).

Thanks, Leonard

[stephen]

Leonard,

If the company is a c-corporation and the owner qualifies for a 1042 election (in part by selling at least 30% of the company to the ESOP) he can invest the proceeds from the sale tax free. Thus, depending on the size of the company he could get the $560,000 all right now. This would allow it to grow to significantly more than $560,000.

Another option would be for the owner just to receive his prorata share of the shares based on his compensation. I have seen where in a small company the owner can actually benefit more this way than if he had elected 1042.

However, if the company is an s-corporation 1042 is not an option. Also ESOPs do not work well for small s-corporation companies due to the 409(p) restrictions.

Good luck on your project.

[Guest lwbarry]

Hi Stephen,

Thank you very much for your comments. I thought about telling the hypothetical business owner in my project to sell now and invest the proceeds. However, the goal is for him to accumulate $560,000 in addition to his other assets. The business is one of his “other assets,” so if he sells the business, he gets $ but doesn’t own the business anymore. Then the question becomes, how would his return in the stock market compare to what his return would be on the business?

So assuming the owner doesn’t sell now and invest the proceeds, does an ESOP make sense? I was thinking it might not, because the owner would be receiving his prorata share of the shares, and he owns the business already anyway—what he really needs is cash to invest elsewhere, so that when he retires, he has the value of the business + whatever the cash from his retirement plan has grown to.

But you mentioned you have seen a small company owner benefit more from receiving the pro rata share of the shares than from receiving cash. I’m very curious to hear more details. As a student, this is all theoretical for me, so real-world examples are the best thing.

Thanks again, Leonard

[stephen]

The particular case was a small engineering firm were the owner and #2 employee earned roughly 60% of the compensation for the firm. Thus their ESOP allocations each year were worth more over time than the 1042 benefit would have been.

To elect 1042 the owner need only sell at least 30% of the company to the ESOP thus he could still own 70% of the company and have the 30% divested of the company and invested. An ESOP works great as an exit strategy for an owner who needs a buyer and wants to transfer ownership of the company to the employees. If your hypothetical owner is not interested in doing this perhaps a cross tested plan or defined benefit plan would be a better fit.

[Guest lwbarry]

Hi Stephen,

Thanks again!

Leonard