Insurance agency owners are quickly embracing this concept, but they face many challenges. This includes developing a fund growth strategy, making additional investments in their businesses, creating a perpetuation plan, and optimizing employee productivity. All of this while being tax-advantaged.
ESOPs are a viable option for principals and agency owners who face any or all of these issues.
What is an ESOP?
An ESOP (exempt from tax) is a retirement plan that holds stock in the sponsoring company to benefit its employees. It is important that ESOPs have the same restrictions and limitations as other tax-qualified retirement programs, such as a 401K.
An ESOP is a combination of a corporate finance tool and a retirement vehicle. This is what makes it different from other plans. An ESOP is different from other plans in that it can borrow money from shareholders to buy its sponsor’s stock or directly from the company.
As an employee benefit, employers can contribute stock annually to the ESOP. This is commonly referred to as an ESOP that is not leveraged.
An outside lender can lend funds to the ESOP to buy company stock. This creates a leveraged ESOP.
The benefits of ESOPs can be divided into two categories: the company and shareholder advantages.
Shareholder Advantages
Ownership transfer is made easier by the shareholder benefits. This is a very efficient way to transfer ownership in closely held agencies. A leveraged ESOP allows an agency to transfer ownership from one or two owners to another by using the right strategy. This makes it very economical to manage a perpetuation program, regardless of whether it is performed over time or all at once.
ESOPs can be used to facilitate ownership succession and buy out dissident shareholders. By using section 1042 tax-free rolling over, shareholders may be able get a tax deferral. This increases the purchase price and maximizes shareholder cash. Leveraged ESOPs that are used to buy out a partner have a lower cost because principal and interest repayments are fully tax-deductible.
If a shareholder chooses to keep his stock until death, the estate can use the ESOP as a way for the agency redeem the stock tax-deductible. Instead of using after-tax dollars for redemption, the agency can make tax-deductible contributions towards the ESOP to purchase the stock. The estate cannot sell some of its stock to the agency to raise funds to pay estate taxes.
The sale of company stock to an ESOP may be tax-deferred for an unlimited period. The process involves forming a leveraged ESOP to sell the owner’s shares and then reinvest the proceeds in securities from qualified U.S. businesses. To qualify for tax-deferral, you have a short time limit on your investment.
Agency owners can cash out on their business’s value and defer federal income taxes on the proceeds. This benefit is only available to C-corporation shareholders. C corporations are entities that are taxed at company level, rather than allowing income to be passed through to shareholders.
Agency owners can use the rollover that is available to C-corp shareholders to obtain liquidity for their agency ownership. Reinvesting in qualified U.S. investment allows them to defer capital gains treatment and diversify their holdings, which reduces personal risk.
Company Advantages
One of the benefits for a company is the ability to raise capital at a lower cost. Agency can quickly get capitalization for expansion and other purposes by forming a leveraged ESOP. This method has the greatest advantage: agencies can take a complete tax deduction for principal and interest repayments.
The tax laws allow agencies only to deduct interest from conventional lending sources. A leveraged ESOP, however, allows for the deduction of principal and interest costs.
ESOPs are also more likely to access capital via funding sources than other methods such as banks and venture capitalists.
An ESOP could have other benefits. It can improve a company’s culture by allowing all employees to retain “pride in ownership.” Owners should notice a significant change in culture by allowing employees to take ownership of the agency. The ESOP can help increase employee morale, reduce turnover and improve productivity.
Due to their complexity, many insurance professionals are reluctant to explore the possibility of ESOPs. An advisor can help you understand their benefits and applicability. An attorney is required to assist with ESOPs.
Agent owners should consider establishing an ESOP to benefit from the significant tax incentives provided by Congress. ESOPs offer tax-saving opportunities that are unmatched by any other planning method.
Steven Wevodau works as an independent consultant in the financial and insurance services industries. Steven Wevodau is a veteran executive with over 25 years experience.
