Worker cooperative is simpler than employee stock ownership plan

“I have run a successful service business for many years.

“I am getting ready to retire and have been approached by several local competitors who would love to buy my business.

“The problem is that I have several long-serving employees in their 40s and 50s who would probably be terminated if I sold the business, with little chance of their being re-employed in this area.

“I would prefer to sell this business to my employees, but an ’employee stock ownership plan’ (ESOP) sounds too complicated for a small business like this one.

“I’ve been reading online about ‘worker’s co-operatives’ that can be set up using a limited liability company (LLC), but as I understand them LLCs cannot retain earnings — everything must be distributed to the owners at year-end, which would prevent this business from growing over time.

“Could you please address this in one of your future columns?”

First of all, this reader gets my nomination for sainthood. Most of my retiring clients would grab at the cash being offered by the competitors and leave their former employees twisting slowly in the wind.

The concept of a worker cooperative, dating back to the 1930s in the United States, is beginning to be dusted off and looked at with fresh eyes, not only in situations like this one but in millennial-owned ventures that are rejecting the traditional pyramid-shaped hierarchy in favor of a more collaborative (some might say socialistic) approach to management.

In a worker cooperative, the employees run the show and own the stock. Decisions are either made directly by the employees in periodic meetings or by a committee of employees who handle the day-to-day business, leaving only big decisions to a vote of all employees.

An employee stock ownership plan, or ESOP, is a tax-driven device designed to give employees a stake in the future profits of the business without necessarily giving them management rights. The IRS rules for ESOPs are very complicated and easy to foul up (which explains why most ESOPs are managed by professional investment firms for sizeable fees). I agree it probably would not be appropriate for this reader’s company. (For more information on ESOPs, visit www.investopedia.com/terms/e/esop.asp.)

A handful of states have created special cooperative corporations for worker-owned companies, and most other states allow cooperatives to be formed as nonprofit corporations. However, corporate income is taxed twice, and nonprofits cannot legally distribute profits to owners (as opposed to paying workers’ salaries).

Accordingly, the LLC has emerged as the preferred vehicle for setting up a worker co-op in the U.S. Here’s how it might work for this reader:

  • The employees would form an LLC under state law, with each employee having an equal share in profits and losses. (So, if there are six employees, each one would have 16.66 percent ownership interest in the LLC).
  • The LLC would be run either by the employees as a group (“member-managed”) or by a committee of employees who have the most management experience (“manager-managed”). If a worker quits, dies, becomes disabled or retires, his or her ownership interest in the LLC would be sold back to the LLC (or the other employees) for a predetermined price.
  • The LLC would then buy the assets of the existing business and give a promissory note to the retiring owner offering to pay him back over time with interest at prevailing commercial rates (currently 6 to 8 percent per annum).
  • The LLC would make monthly payments to the retiring owner before paying salary and benefits to the employee-owners.
  • As in any LLC, the employees would pay taxes on their percentage share of the LLC’s profits and losses.

This structure should work for a really small business. However, there are a number of potential problems:

  • If the LLC tries to retain more than $250,000 in earnings without distributing it to the employee-owners, it will be subject to an excess profits tax of about 40 percent.
  • The LLC members who are managing the enterprise have a fiduciary duty to the LLC (something ordinary employees don’t) and can bind the LLC to contracts and debts without the knowledge of the other employees.

To avoid these problems, the LLC could elect to be taxed as if it were a corporation or subchapter S corporation, but doing so would eviscerate many advantages of the LLC (such as simplicity of operation and the ability to bring non-U.S. citizens onboard as owners).

There are several other more creative ways to work around these problems (for an excellent article on this, visit http://cdi.coop/coop-llc-retain-earnings), but all of these will complicate the LLC’s operations and require sophisticated tax planning advice.

The biggest obstacle to worker cooperatives of any kind is getting employees to think like managers and owners. To paraphrase George Orwell’s “Animal Farm,” while all members of a worker cooperative LLC are legally “equal,” some may have to be “more equal than others” for the business to enjoy long-term success.•

Cliff Ennico (crennico@gmail.com) is a syndicated columnist, author, and former host of the PBS television series “Money Hunt.” The opinions expressed in this column are those of the author.

© 2017 Clifford R. Ennico

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