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What Is An ESOP and Do You Want One? Pros and Cons of the Employee Stock Option Plan

First of All, What is an ESOP?

An Employee Stock Option Plan (ESOP) is a qualified, defined contribution employee benefit plan, under Sections 401(a) and 4975(e)(7) of the Internal Revenue Code, that invests primarily in the stock of a sponsoring employer company.

ESOPs allow employees to acquire an ownership interest in the employer company by participating in the ESOP. An ESOP is unique from other qualified plans in that it may borrow money and engage in related party transactions to acquire company stock from the business owner. As such, the ESOP functions as a means of financing the ownership transition of a closely-held business in a tax-favored manner.

Similar to other qualified retirement plans, ESOPs are subject to the same 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 the contributions to the ESOP, and 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, may apply if the company is publicly traded.

Common uses of an ESOP:

  • 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 a very effective employee retention tool that motivates workers to take ownership of the business, both literally and figuratively. Employees are able to gain stock ownership in the employer corporation and, therefore, have a financial interest in increasing the value of the company. This motivates employees to be more effective, accountable and productive.

ESOP: Initial Setup and Maintenance

The complexity of the initial setup and maintenance of an ESOP is specific to the employer corporation and ESOP design. The employer company creates a trust into which it will make annual contributions. The contributions are appropriated to employee accounts within the trust. The allocation may be in proportion to compensation or years of service, or a combination of the two. Employees may be eligible for allocation after one year of employment or 1,000 hours.

Stock or assets allocated to employee accounts must vest before they are distributed to employees. Vesting is an ERISA guideline that stipulates employees are entitled to the plan benefits within a certain period of time. The vesting period may range from 20 percent per year until employees are fully vested after six years of service, to the entire employee account vested immediately.

Vesting and other Considerations

When an ESOP employee who has at least 10 years of participation in the ESOP reaches age 55, he or she must be given the option of diversifying his/her ESOP account up to 25 percent of the value. This option continues until age 60, at which time the employee has a one-time option to diversify up to 50 percent of his/her account. 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 ESOPs

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 a very attractive means of accomplishing an owner’s exit strategy. If structured properly, a leveraged ESOP can provide benefit to all parties involved.

Advantages of a leveraged ESOP include:

  • Enhancing cash flow,
  • Obtaining financing,
  • Increasing productivity,
  • Motivating employees, and
  • Attracting 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 put in escrow and released as the loan is repaid. With a leveraged ESOP, both the loan interest and principal are tax-deductible (up to certain limits). This is a distinct tax advantage, and can greatly increase operational cash flow.

A leveraged ESOP also allows a company to defer paying some of the plan’s benefits to employees until the loan is fully repaid. Additionally, dividends paid on the ESOP stock are passed through to employees or used to repay the ESOP loan are tax deductible, which increases cash flow availability versus conventional financing.

Increased Productivity and Other Benefits

An ESOP can be a viable tool for motivating employees and increasing productivity. The increase in productivity is likely to lead to significant profits, company value and future employee benefits. Further, owners do not have to give up operational control of the business.

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

Disadvantages to an ESOP

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 the legal and tax issues to reap the full benefits of the ESOP.

Further, 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 he/she desires to retire. When exercised, 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.)

Another ESOP negative may arise from a failure on behalf of fiduciaries if fiduciary duties are breached; this may expose the employer corporation to potential damages, claims and/or hefty excise taxes (i.e., selling stock to the ESOP at inflated prices).

It must be mentioned that S corporations may have ESOPs as owners. While there are tax advantages when an ESOP owns 100% of an S corporation, this type of ESOP does not qualify for tax-free rollover treatment, 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 that is covered by the 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 tradeable must be conducted by an independent appraiser. The valuation of the stock must be conducted annually.

It is important that the price paid by the ESOP for the employer stock is 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

Fair market value is defined by the DOL proposed regulations as the amount at which the company stock would change hands between a willing buyer and a willing seller, each having reasonable knowledge of all relevant facts, neither being under any compulsion to act, and with equity to both.

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

ESOP trustees must only engage an experienced valuation analyst who is 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 assessing the feasibility of an ESOP is the value of the employer corporation. However, other factors, quantitative and qualitative, must be considered.

  • Successor management team: For an ESOP to be a successful means of exit for a business owner, there must be a successor management team identified who will support the ESOP. If this team does not exist, an 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 (i.e., 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 that are already highly leveraged, as the ESOP will likely interfere with business growth plans.
  • Earnings history: The employer corporation must have a strong history of earnings and cash flow. This level of earnings must be expected to continue into the future.
  • Balance sheet: If owners are contemplating a leveraged ESOP, the employer corporation must have a strong balance sheet with sufficient equity and therefore not overly leveraged.
  • §1042 rollover: If a leveraged ESOP is planned, 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 the capital gains tax on stock he or she sells 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 another 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 ESOP Right For You?

ESOPs are a viable option for business owners who are seeking a funding source for their retirement, and who have the management team and company cash flow to make that happen. The plan creates liquidity, motivates employees, and fosters a favorable corporate culture for profitability and accountability. Owners have many options by utilizing an ESOP, including exit strategy planning, ownership retention, continuity of the business legacy, and financing the ownership transition in a tax-favored manner.

[Editor’s Note: If you want to read more about how to sell or otherwise exit a business, be sure to read “Business Transition and Exit Planning: Welcome to the Jungle!” It will lead you step-by-step through what you need to know.

To learn more about this and related topics, you may want to attend the following webinar: ESOPs 101. Read more about Business Transition and Exit Planning.]

About Erin D. Hollis

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