Business leaders understand the importance of balance in growing a sustainable company, and make daily decisions that demand attention to finding the right level of equilibrium. New opportunities bring potential for both risk and reward. You have to meet today’s business needs while anticipating tomorrow’s.
Balance is especially important for employee stock ownership plans and the companies they own — and it grows increasingly important as an ESOP matures. In a nutshell, here’s why:
As an ESOP matures and pays off its initial debts to business lenders and note holders, its tax advantages can help strengthen its cash position.
It’s a wonderful “problem” to have, but leadership needs to strategically plan how it will use ESOP capital both to support sustained growth and to secure your ability to pay future ESOP plan distributions.
In this article, we’ll review:
- ESOP tax benefits that support a cash advantage
- Leadership’s fiduciary duties under the Employee Retirement Income Security Act of 1974 (ERISA)
- How ESOP leaders address the “paradox of success” to balance business growth needs and plan sustainability
How ESOP Tax Benefits Can Generate a Competitive Cash Advantage
In the case of leveraged ESOPs — which includes most new plans — C corporations’ tax deductions and S corporations’ tax-advantaged status enable them to use cash that otherwise would have paid income tax to service an ESOP loan. For either type of corporation, the ESOP tax benefits can significantly improve cash flow, making it easier to pay off the loan. And once the loan has been satisfied, ESOP-owned companies need to keep a strategic mindset about how best to utilize their tax advantages to further strengthen the business.
What are those tax advantages? For C corporations, it’s the continued tax-deductibility of ESOP contributions. For ESOP-owned S corporations, it’s their exemption from paying federal (and most state) income taxes. Remember, a 100% ESOP-owned S corporation can be income-tax free — in perpetuity.
In both cases, that cash advantage can support strategic reinvestments in the company. Growth initiatives, distinctive employee benefits, and your ESOP’s capital improvements could all get a boost. That calls for a balanced focus on reinvestment, building dependable cash reserves, and paying shareholder dividends (if the ESOP chooses to pay dividends).
Addressing the Paradox of Success in an ESOP
Many mature ESOPs discover a need for a plan that addresses the “paradox of success,” in which the company’s growth raises its share value, and its ownership culture improves retention … all contributing to its long-term financial obligations, as it will have to buy back departing employees’ shares.
Unlike shorter-term employees who exit after a year (or two or three), long-term employees are fully vested at departure, and the value of their shares has had years (or even decades) to increase. Those ESOP plan distributions can add up, and that calls for a plan.
An ESOP company’s strategic plan should account for its ESOP’s sustainability when evaluating opportunities like expansions or operational reinvestments, for example.
ERISA Requirements and ESOP Fiduciary Duties
Adhering to ERISA standards and meeting ESOP fiduciary expectations are of the utmost importance when it comes to managing company cash. Leaders should be ready to navigate any regulatory nuance and ensure they’re operating in the best interests of the plan and its participants. This includes prudent investment of company funds, transparent financial reporting, and ensuring that the repurchase strategy doesn’t jeopardize business health, company growth, or ESOP viability over time.
Expert Guidance Is Essential
An ESOP sustainability study typically starts by establishing a clear understanding of the cash your company will need to meet short-term and long-term stock repurchase obligations and ensure the most cash efficient practices are being utilized. With study results in hand, your ESOP company leadership can make informed, prudent decisions about how and where to reinvest its cash reserves.
From there, the insights of an experienced, trusted business lender and/or financial advisor can help identify opportunities to responsibly grow cash reserves in ways that support long-term growth — without compromising the company’s ability to make timely distribution payments to departing employees. Lenders and advisors who really know ESOPs can help uncover financial strategies and investment opportunities that align with your company’s growth goals and your ESOP-driven, employee-focused values.
RELATED: Why Business Lenders Should Champion ESOPs
Keep in mind, the need to balance growth-driven investments with repurchase obligations is a business circumstance most companies would prefer to have (compared to the alternative). The right expert help can make it much simpler to leverage tax benefits, plan strategically, and sustain both a healthy ESOP and robust business growth. Request a consultation to learn more about sustainability studies, or start learning now with our free tip sheet on how to forecast, report, and fund your repurchase obligations. Click below to get your copy.
