Should Your Business Use an ESOP?

The Pros and Cons of the Employee Stock Ownership Plan

What Is an ESOP?

An Employee Stock Ownership Plan (ESOP) is an employee retirement benefit trust. These plans represent sums of money contributed to each employee’s account over time. Those employee accounts purchase shares of stock and other assets in the sponsoring employer company. An effective ESOP usually offers more benefits the longer an employee stays with the company. ESOPs allow participating employees to acquire an ownership interest in the employer company. An ESOP differs from other qualified plans in that the fund may borrow money and engage in related party transactions to acquire company stock from the business owner. 

As a result, an ESOP can function as a means of financing the ownership transition of a closely-held business in a tax-favored manner. In essence, you sell interests in your company to employees who have a personal commitment, instead of selling the business to a single buyer whose interests may not align with yours.

Similar to other qualified retirement plans, ESOPs are subject to general regulatory requirements and laws of the Internal Revenue Service (IRS), the Department of Labor (DOL), and the Employee Retirement Income Security Act of 1974 (ERISA). The IRS oversees the deductibility of contributions to the ESOP (under Sections 401(a) and 4975(e)(7) of the Internal Revenue Code). The DOL ensures the plan is properly administered and that participants in the ESOP are treated fairly. Federal and state securities laws, including Securities and Exchange Commission (SEC) regulations, apply if the company is publicly traded.

How Employers Might Use ESOPs

• Buying stock of a retiring or departing shareholder
• Creating liquidity for shareholders
• Estate planning
• Management succession planning
• Capital for expansion
• Acquisitions
• Leveraged buy-out by management
• Motivating employees
• An employee benefit
• Charitable giving

If done properly, an ESOP can be an effective employee retention tool that motivates workers to take ownership of the business, literally and figuratively. This is especially true for startups that may not have cash to provide immediate employee benefits but are optimistic about the company’s growth. Through the ESOP, employees are able to gain stock ownership in the employer corporation and, therefore, have a financial interest in increasing the value of the company. Having a financial stake can motivate employees to be more effective, accountable, and productive.

Employee Stock Ownership Plan Setup and Maintenance

The initial setup and maintenance of an ESOP is specific to the employer corporation and ESOP design, but the basics are as follows:

• The employer company creates a trust into which it will make annual contributions.
• Contributions are appropriated to employee accounts within the trust.
• Such allocations may be in proportion to compensation, or years of service, or a combination of those. 
• Employees may be eligible for allocation after the vesting period — for example 1 year of employment or 1,000 hours.
• Stock or assets allocated to ESOP accounts must vest before they are distributed to employees.

Vesting means employees are entitled to plan benefits subject to a certain period of time. The vesting period varies. Some plans distribute perhaps 20% per year until employees are fully vested after 6 years of service. Others allow the entire employee account to be vested immediately.

Vesting and Other Considerations

When an ESOP employee with at least 10 years participation in the ESOP reaches age 55, they must be given the option of diversifying their ESOP account up to 25% of the value. This option continues until age 60, at which time the employee has a one-time option to diversify up to 50%. Employees may receive the vested portion of their accounts upon termination, disability, death, or retirement.

The employer corporation must give the participating employee a “put option” on the stock. A “put option” gives the employee the right to sell a specified amount of stock at a specified price and time. Therefore, the company must have enough liquidity to satisfy this obligation when the employee exercises the option.

Leveraged Employee Stock Ownership Plans

Only a small number of companies are in a strong enough financial position to buy out an owner in an all-cash purchase. Consequently, utilizing an ESOP in conjunction with debt financing is an attractive option for an owner planning an exit strategy. If structured properly, a leveraged ESOP can benefit all parties.

Advantages of a leveraged ESOP include:

• Enhancing cash flow
• Obtaining financing
• Increasing productivity
• Motivating current employees
• Attracting new employees

In a leveraged ESOP, the employer corporation borrows money from a lending institution or the existing owners to buy company stock. The stock is held in escrow and released as the loan is repaid. With a leveraged ESOP, the loan interest and principal are tax-deductible within certain limits. This is a distinct tax advantage and can greatly increase operational cash flow.

A leveraged ESOP allows a company to defer paying some of the plan’s benefits to employees until the loan is fully repaid. Dividends paid on the ESOP stock are passed through to employees or used to repay the ESOP loan. Either way, these dividends are tax deductible and increase cash flow availability compared to conventional financing.

Increased Productivity and Other Benefits

An ESOP can motivate employees and increase productivity. Increased productivity leads to increased profits, company value, and future employee benefits. Owners do not have to give up operational control of the business if they decide to offer an ESOP.

There are significant tax benefits to setting up an employee stock ownership plan. An owner can sell as little as 30% of the employer corporation to the plan. An ESOP provides the owner with a means to retain control of the business while selling a portion of the stock free of capital gains tax.

ESOP Disadvantages

Of course, as with any qualified employee benefit plan, there are disadvantages. An ESOP transaction involves several different professionals: valuation, legal and regulatory, qualified plan administration, finance, and fiduciary responsibility. Owners must be aware of legal and tax requirements to reap the full benefits of an employee stock ownership plan.

The employer corporation must be financially strong enough to handle debt payments without jeopardizing company operations. The departing owner must also have a knowledgeable management team if the owner plans to retire. A put option may cause a cash flow shortage if too many employees exercise this option at once. To avoid this, the company can set aside cash or buy insurance to offset cash flow depletion.

Additionally, if a trustee breaches fiduciary duties, the employer corporation may face potential damages, claims, and/or hefty excise taxes. 

It must be mentioned that employee stock ownership plan trusts may own S corporations. There are tax advantages when an ESOP owns 100% of such a corporation, but an ESOP does not qualify for tax-free rollover treatment. They cannot deduct dividends and must apply interest payments on an ESOP loan toward contribution limits. Nevertheless, as with all pass-through entities, income is not taxable at the corporate level.

Qualified ESOP and Trusts

Every qualified ESOP is part of a trust covered by ERISA. The trust is overseen by the ESOP trustee. Under ERISA Section 401(a)(28)(C), all valuations of employer corporation stock that are not readily tradable must be conducted by an independent appraiser. Valuation of stock must be conducted annually.

The price paid by the ESOP for employer stock must be of adequate consideration. Adequate consideration is defined by ERISA Section 3(18)(B) as, “the fair market value of the asset as determined in good faith by the trustee or named fiduciary […] pursuant to the terms of the plan and in accordance with regulations promulgated by the Secretary of Labor.”

Following the Fair Market

DOL proposed regulations say fair market value is

 “…the price at which an asset would change hands between a willing buyer and a willing seller when the former is not under any compulsion to buy and the latter is not under any compulsion to sell, and both parties are able, as well as willing, to trade and are well-informed about the asset and the market for that asset.”

An independent valuation analyst must provide a theoretically justifiable  valuation that incorporates all appropriate methodology and analysis. The valuation must provide the ESOP trustee the information required to make sound financial decisions for the plan. The valuation analyst must understand ERISA, DOL, and IRS guidelines and take into consideration the impact of employee put options, especially payment terms and the company’s ability to meet repurchase obligations.

ESOP trustees must only engage an experienced valuation analyst certified by a recognized professional valuation association such as the American Society of Appraisers (ASA).

Quantitative and Qualitative Factors of an ESOP

One of the first things to consider when deciding whether to establish an ESOP is the value of the employer corporation. There are other quantitative and qualitative factors to consider.

• Successor management team — For an ESOP to be a successful exit strategy for a business owner, there must be a successor management team to support the ESOP (without this team, and ESOP is not a viable option).
• Corporate culture — The corporate culture must be favorable to a shared management style.
• Company size — The employer corporation must be large enough to warrant an ESOP. It must have more than 20 employees and more than $250,000 in payroll.
• Company age — The more mature the employer corporation the better. An ESOP is not suitable for start-up companies or those  already highly leveraged, as the ESOP may interfere with business growth plans.
• Earnings history — The employer corporation must have a strong history of earnings and cash flow which is expected to continue into the future.
• Balance sheet — The employer corporation must have a strong balance sheet with sufficient equity so it is not overly leveraged.
• §1042 rollover — The employer corporation must be a C corporation for the owner to take advantage of 1042 rollover treatment. The owner of a C corporation can defer capital gains tax on stock sold to the ESOP if 1) the ESOP owns 30% or more of each class of outstanding stock or of the total value of all outstanding stock and 2) the seller reinvests (“rolls over”) the sale proceeds into qualified replacement property during the period from 3 months before to 12 months after the sale.
• Existing retirement plans — The employer corporation may already contribute to an existing benefit plan for its employees. An existing plan may indicate the company’s ability to engage in a new plan as well as indicate the employees’ ability to be motivated or incentivized by an additional employee benefit plan.
• Administration costs — All parties involved must be aware of the administrative costs of an ESOP. A company’s cash flow must be able to sustain additional annual legal, accounting, and appraisal fees.

Is an Employee Stock Ownership Plan Right For You?

ESOPs are viable for business owners seeking a funding source for their retirement if they have the management team and cash flow to make it happen. Owners may recognize multiple options with employee stock ownership plans, including exit strategy planning, ownership retention, continuity of the business legacy, and financing the ownership transition in a tax-favored manner.

[Editors’ Note: If you are developing a business exit strategy, you may like Business Transition and Exit Planning: Welcome to the Jungle! To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each include a comprehensive customer PowerPoint about the topic):

• ESOPs 101
• Roadmap to Selling a Business or Taking on Outside Investors
• Board of Directors Boot Camp

You may also like:

• Planning and Staging a Company for Transition
• The Benefits of an ESOP Transaction for the Seller and the Company

This is an updated version of an article originally published on June 25, 2019, and was most recently updated by Courtney Smith]

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