Thursday, May 9, 2013

The JBM S-Corp Strategy

Since the Annual ESOP Association Conference begins today, it seems appropriate to say a few words about a strategy for new ESOPs that most closely approaches the concept of “Capital Homesteading” within the framework of current law and is consistent with the Just Third Way and Justice-Based Leadership and Management as far as the law allows.

Let’s first consider the “typical” ESOP.  By routing debt through an ESOP, a “qualified retirement plan,” all debt service payments (interest and principal) are deductible as “deferred compensation expense.”  An ESOP is thus the only way that it is possible to deduct payments of principal on a capital acquisition loan as a legitimate business expense.

Now let’s look at what happens when profits are distributed.  When a company is organized as a C-Corp, annual ESOP contributions, dividends paid on stock owned by the ESOP used to make debt service payments or passed through to the Plan Participants, and interest on stock purchase indebtedness (the “acquisition loan”) can be deducted so as to greatly reduce the taxable income of a company.

That, in and of itself, is a tremendous and very profitable benefit to both management and the worker owners.  There is, however, an even better arrangement.  Under current law, when a company is organized as an S-Corp and is owned 100% by the workers through an ESOP Trust, the company pays no state or federal corporate income taxes.  This is the case whether or not the company makes contributions to the ESOP or passes any distributions through the ESOP Trust to Plan Participants.

In other words, a company can pay down debt with untaxed dollars.  This is because annual contributions and dividends are paid out of income that is not subject to taxation.  A company can increase working capital through elimination of corporate income tax liability. This effect is due to a company being an S corporation as income flows through to a tax-exempt trust.

A company can sponsor an ESOP trust to which it will make annual contributions, which can be allocated equally to individual Participant accounts. The shares of company stock and other plan assets allocated to Participants’ accounts will vest in the Plan Participants; and the Participants will receive the vested portions of their accounts at termination or retirement in cash, after the appropriate Break-in-Service.

Further, a Plan can have “cliff vesting” (i.e., 100% vesting) after two or three years instead of an incremental vesting schedule.  This will emphasize the ownership aspect of the company.  According to studies reported by the National Center for Employee Ownership in Oakland, California, employee ownership combined with participatory management and profit sharing significantly enhances profitability over otherwise comparable firms.

All in all, it is baffling why any company today would not want to take advantage of such benefits, but there is no accounting for tastes.

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