ESOPs as a means to cash liquidity tax deductions.
Transferring the ownership of part of your business to employees under an employee stock ownership plan may not be something you've seriously considered lately. But for many companies, especially those looking to reduce their debt service and operating costs, setting up an ESOP can provide several benefits at once. Although advocates for years have touted ESOPs for the way they can make employees more motivated and productive, less attention has been paid to how ESOPs can lower your cost of capital.
There are several financial benefits to setting up an ESOP. To begin with, assuming the ESOP is buying 50% of the stock, you can deduct not just the interest payments on loans to the ESOP but the principal as well. (On ordinary business loans, only interest expenses are deductible.) "If you look at the payments over time, this is by far the biggest benefit," says Lawrence Mack, a vice-president with Ameritrust, a Cleveland bank. "It can really help cash flow."
Bankers who have experience with ESOP loans tend to feel positive about them. Over and above the cash-flow advantages, which reduce the risk that a company won't be able to meet its loan payments, there's another attraction: half of the interest a company pays on an ESOP loan is tax deductible to the lender, boosting the potential return on an 8% loan to as high as 12%.
Still, ESOP mavens caution against looking to ESOPs for short-term financial gains. Given all the tax and legal issues, it takes at least several months to set one up. And because of the high legal and accounting costs (we've heard of fees ranging from $10,000 to more than $100,000), ESOPs probably won't make sense for companies with payrolls of less than $500,000. If you're interested in exploring an ESOP, two sources of information are the National Center for Employee Ownership, in Oakland, Calif. (510-272-9461); and the ESOP Association, in Washington, D.C. (202-293-2971).