Entrepreneur Lorraine Wardy had already retired once when she entered the portable sanitation business. After running a surf shop for five years, she started a women’s sportswear and apparel manufacturing company, running it from 1985 to 2000, when she retired.

But she soon got restless, and in 2001 purchased Sarabia’s Portable Jons in El Paso and built that business. Now she’s ready to retire again. But instead of selling out to a new owner, Wardy decided to sell it to her employees through an employee stock ownership plan (ESOP).

In an ESOP transaction — regulated by the U.S. Department of Labor and Internal Revenue Service — the owner sells company stock to the ESOP itself, which then holds it on the employees’ behalf. Wardy is selling 90 percent of her stock in Sarabia’s to the Sarabia ESOP and will keep 10 percent. Over an 8- to 10-year period, the ESOP will pay for her shares with cash generated by the company’s day-to-day operations.

Wardy and her accountant, John Beakley of Beakley & Associates, Lubbock, Texas, spoke with Pumper about the ESOP conversion.

Pumper:

What exactly is an ESOP, and why might a company set one up?

Beakley:

An ESOP is a profit-sharing plan that is authorized to invest 100 percent in employer-issued stock. In a regular profit-sharing plan, buying stock from a shareholder is prohibited. In an ESOP that’s authorized.

For an owner who wants to sell and still take care of their employees in the process, an employee stock ownership plan is really a very good option. The tax advantage for a company owner willing to sell to an employee stock ownership plan and carrying the loan is huge.

Wardy:

We have grown this company tenfold in the last 10 years. My employees have really made this company happen. I felt if I could do that for them, with advantages to me, why not?

Pumper:

What is the process to set one up?

Beakley:

The company has to establish the plan documents. Then the company stock has to be independently valued by a valuation firm. When you’re negotiating with a third party that wants to buy your business, it’s just what the buyer’s willing to pay and the seller’s willing to sell for. In an ESOP, because you don’t have a true, independent third-party buyer, the owner can’t just determine what they think it’s worth. The Department of Labor and the Internal Revenue Service require that the stock be valued for the initial transaction and then every year after that as long as the ESOP owns the stock.

The initial valuation is probably going to cost at least $10,000. The plan document can cost $25,000 to $50,000. After the valuation, the owner determines whether they can live with that price, and if that’s going to accomplish the purposes that they want to (for the owner’s personal investment portfolio).

Pumper:

Who gets the tax deductions involved in the ESOP transaction?

Beakley:

The company gets the deduction (for) making a contribution to the retirement plan — the ESOP.

Also, the seller is selling their stock as opposed to someone wanting to purchase the assets of the company. Historically, sales of stock have enjoyed long-term capital gains treatment (and) have been taxed at a preferential rate (currently 15 percent, compared with 35 percent for ordinary income).

If a buyer was only buying your assets, not your stock, the company has to pay tax on the gain on the sale of those assets. Corporations don’t get preferential long-term capital gains rates, so they’re paying 40 percent. The owner then only gets 60 percent (of the sale price), and has to pay another 15 percent on the long-term capital gains.

Wardy: The other thing is that usually with companies like this one, the new buyer might give the owner a down payment and then finance the balance. But at that time they want the owner to leave. If I’m going to have to finance (a buyer), I’d rather finance my own employees and then stay here, so somebody doesn’t hand me the keys four years later and say, “Here’s your company back — sorry. It didn’t work.”

Pumper:

Once the ESOP is established, do the employees actually get the stock themselves?

Beakley:

They never actually receive the stock directly. As long as they remain an employee of the company, the ESOP holds the stock on their behalf. It’s a retirement plan. The benefit is completely deferred as far as the employee is concerned.

There’s a vesting schedule: If you stay at least two years, then that third year you become 20 percent vested. After you’ve been in the plan more than six years you’re 100 percent vested in your stock.

Wardy:

This past December we did the sale of the stock into the ESOP. There hasn’t been any money paid to me yet. They do pay me interest on the note that I am financing for the ESOP. (Employees began accumulating individual shares of stock in September of this year.)

Pumper:

So the employee accumulates an interest in stock held for them by the ESOP. When it comes time for the employee to retire, what happens?

Beakley:

Hopefully over a 15- 20- 25-year career, the value of the company increases above what the value the ESOP had to pay the original owner for the stock. So if an employee retires or leaves after vesting, the ESOP pays them (to buy back their stock). If it’s a small enough balance and the company’s got the cash, then they can just write them a check for payment in full. (For larger amounts, the ESOP might pay the departing employee over several years.) The employee has the option of rolling those proceeds over into an IRA, where they don’t have to pay tax on it until they start taking annual distributions.

Pumper:

Is the ESOP of primary interest to a company whose owner doesn’t have heirs? Or could it be of interest to a company in any kind of situation?

Beakley:

It’s really the owner’s preference. You have to have a stable pool of employees, and once the owner steps back and turns over control of the company, somebody has to run the company. So you’ve either got to hire professional management to come in and run it, or during this loan payout period, you grow up and improve the management capabilities of a couple of your key employees.

Wardy:

Not every company is a good candidate. It can’t be a company in financial problems; that won’t work, because there’s debt to be paid.

I’ve got to get paid. And it’s going to be paid two ways: from the same earnings of the company, or you’re going to borrow the money to be paying it. I did not want to laden the company with financial pressures from more bank debt. So we are financing the purchase, which is going to take about eight to 10 years.

Pumper:

When you decided to implement this plan, was it difficult to communicate to employees so they could understand how it works? What’s been the actual employee reaction to the ESOP program?

Wardy:

It’s an ongoing process. The employees, some of them are savvy and some are not. The way our ESOP is set up it very clearly is favoring the employees. It’s very transparent to make sure that this is not just a way for Lorraine to get money. Those that understand what’s going on are very excited about it. There is a segment of the population in our company that doesn’t quite understand it and probably won’t until they actually see something in paper.

The whole culture of our company has changed some. Even though they don’t quite understand it, they know that something’s brewing. And so they’re a little more attentive to things. I am now in the process to make entrepreneurs out of my employees so they can really take it over eventually.

Once the employees understand that everything they contribute to this company is going to pay them back tenfold, I think the advantages of having an employee-owned company are going to be huge. I want to retire. But I want to look at this company from far away and see what I created. I want this company to just flourish into something wonderful. I feel like somebody within our company will rise to the top and be great management, but maybe they don’t know that yet.

Pumper:

Is it possible to know whether you’re able to attract workers because this plan is in place? Has it become a selling point in recruiting?

Wardy:

We haven’t really recruited that many. Our business, like everybody else, is slower. We as a team are looking for ways to increase our revenue in other avenues. I think it will be relevant if we have employees to hire. But we haven’t really hired anybody that it has made a difference to them yet. Our employees are aware that this is a long-term benefit. They’re not going to see any real benefit for the next five to 10 years.