Using an ESOP to Grow Your Business

Employee stock ownership plans usually make the news when a company owner uses one to sell the company to employees. But ESOPs are more than an exit strategy for business owners. They can also be a great way to grow your business while keeping your tax bill low.

Many business owners don't realize it, but an ESOP can be a vehicle for making equipment purchases, acquiring another company, or paying off existing debt. Making these moves through an ESOP can yield substantial tax savings as compared with spending company revenue. That's because the ESOP is considered a trust, and money borrowed from the ESOP for purchases or debt payment is excluded from the company's taxable income by the Internal Revenue Service.

Companies with an ESOP in place may find it easier to get a loan. That's because the company loyalty the ESOP inspires makes loan officers view the company as a better credit risk.

In the case of purchasing any type of durable goods that lose value over time, such as office equipment or company vehicles, using an ESOP creates a rare opportunity to deduct the cost twice. The transaction works like this:

1. The company gets a bank loan for the money needed to purchase the goods.
2. The company lends the borrowed money to the ESOP.
3. The ESOP uses the money to purchase an equivalent amount of additional shares in the company.
4. The company buys the goods using the money the ESOP trust pays out.
5. The company is able to depreciate the cost of the goods on its income taxes, writing off the cost as allowed over the years or in a single year, depending on the size of the purchase and current tax law.
6. The entire original bank loan is also a business expense and a tax deduction for the company.

The process works similarly for buying another business. Your company ESOP obtains a bank loan, then purchases shares in the company with the money. The company receives the money in exchange for the shares and makes the purchase. Using the ESOP trust's untaxed dollars to make the acquisition can yield a substantial tax savings, depending on your corporate tax rate.

Paying off debt can also be accomplished with less of a tax burden through an ESOP. When the company takes out a new loan to pay off the old one, it loans the money to the ESOP to purchase company shares. The company then takes the ESOP funds and pays off the existing loan. The new loan's principal and interest payments are all made using pretax dollars.

The tax savings generated by using the ESOP to accomplish business goals benefit not just the business but the employees participating in the ESOP as well. ESOP participants benefit when the company does well, so the reduction in company expenses means more profit and ESOP shares that increase in value.

Note that companies organized as either an S corporation or a C corporation can set up ESOPs, but sole proprietors or partnerships cannot. ESOPs are costly to set up, incurring legal and company-valuation fees that can range up to $100,000 or more. So it probably won't be worthwhile to set up an ESOP unless the planned loan, acquisition, or debt payoff is substantial enough that the tax benefits would be larger than the setup costs. Also, as ESOP shares are granted to workers, business owners reduce their company ownership and control over the company's direction under an ESOP.

Business reporter Carol Tice contributes to several national and regional business publications.