Federal legislation in the 1970s paved the way for Employee Stock Ownership Plans (ESOPs), giving business owners a tax-advantaged way to share broad ownership with employees. ESOPs are one of the most popular vehicles for sharing company ownership with employees. Unlike management incentive plans, ESOPs are designed to provide broad-based ownership to employees at all levels in a company.
In this post, we provide a high-level overview of the benefits of ESOPs as well as important considerations. There may be exceptions to any of these provisions in certain situations or for specific company types – for example, with C-Corporations or S-Corporations. As with any important business ownership decision, owners should consult with qualified attorneys and financial advisors on options and requirements related to ESOP structure, operation, governance, valuation, tax treatment, and other important technical details.
What’s in it for Owners?
Unlike most other exit options, an ESOP provides owners with the flexibility to control the amount and timing of the sale of their company stock. It can also be done independent of the timeline for leadership transition plans, meaning the owner doesn’t have to retire and sell the company at the same time. Many owners are also attracted to an ESOP as a way of preserving their legacy and the unique culture they have built as well as ensuring that ownership and jobs remain in the local community.
There are also tax advantages that may be available to the seller when selling to an ESOP. For example, with the right structure, an owner can defer capital gains tax indefinitely. While the tax advantages for owners can be attractive, they are usually “icing on the cake”, rather than the main motivation to sell to an ESOP.
Giving employees a financial ownership stake in the company can incentivize a higher level of employee performance and a deeper, more personal investment in the company’s success. ESOPs also serve as a valued, competitive employee benefit.
Many studies show that companies with ESOPs enjoy relatively higher growth rates and lower employee turnover.
ESOP-owned companies can also enjoy ongoing tax benefits that can improve cash flow and help finance the ESOP’s purchase of stock.
The most significant tax advantage for ESOP companies is the ability of S-Corporations to shield from federal (and most state) taxes the portion of their profits represented by the ESOP. When the ESOP owns 100% of a company’s stock, there is no federal tax liability for the company’s earnings.
In addition, there are other ongoing tax deductions available to ESOPs, even when the ESOP owns less than 100%.
What’s in it for Employees?
For employees, ESOPs serve as both a retirement plan (similar to a 401(k), only invested in employer stock) and an opportunity to share in the collective success of their company. With very rare exceptions, employees cannot buy shares themselves; they are allocated and granted by the company. This means that employees earn ESOP stock without putting any of their own funds into the plan.
Employees earn ESOP shares in direct proportion to compensation (just like a profit-sharing contribution). Plans typically have eligibility and vesting requirements.
As with other qualified retirement plans, employees are not taxed on their company’s contributions to their ESOP accounts. When an employee retires, the company must buy back their shares at fair market value – a distribution from the plan.
If the employee leaves before retirement age, they can rollover the proceeds to another qualifying plan. As with IRAs and 401(k)s, early withdrawals that are not rolled over are subject to taxes and penalties.
ESOPs are best suited for companies with consistent cash flow, reasonable visibility to future performance, market values above $10 million, a minimum of 40 employees, and borrowing capacity if the owner desires liquidity. As with any exit, owners and advisors should evaluate the impact of an ESOP on the company’s future cash flows and ability to service any new debt or financial obligations created by the ESOP transaction.
As owners consider establishing an ESOP, they should have a realistic understanding of the costs and obligations that come with an ESOP.
ESOPs can be complicated, so they require support from qualified professionals. This also means there is meaningful cost in establishing and maintaining an ESOP. The costs of implementing an ESOP are similar to the costs of selling a company with a full team of advisors. Implementing an ESOP is a 3-to-6 month process with appropriate planning and the right team of advisors.
ESOPs are regulated by the Department of Labor and the IRS. That means an ESOP requires additional compliance and the potential for government scrutiny, regulatory action, and litigation.
ESOPs are not for everyone. In particular, for the seller who needs to extract top dollar for their business, an ESOP is not the right fit. But, for owners who are focused on their legacy, employees, and local communities, an ESOP can be a great path to exit and a fantastic benefit for employees.
With the right professionals on the team, an ESOP can be implemented and maintained to create value for a large group of stakeholders.
Exit Planning Series
WH and Adamy Valuation began a series called “Tactical Tuesdays” in 2020 in response to the impact of the COVID-19 pandemic on our clients and business partners. The goal of “Tactical Tuesdays” was to provide up-to-date information that would allow leaders to make tactical decisions to run their business. As COVID (hopefully) winds down, the Tactical Tuesdays focus is shifting to address longer-term issues. Over the next several weeks, DWH and Adamy will be publishing a series of blog posts around exit planning for business owners.