An ESOP Can Lead to More Productive, Satisfied Employees

An employee stock ownership plan (ESOP) puts the focus on motivating, retaining, and rewarding employees who helped make that business successful in the first place, while also providing an exit strategy for departing owners or founders of an organization.

The Basics

The objective of an ESOP is to provide retirement benefits to the employees through participation in the ownership of the company. The stock is held in a trust for the benefit of the participants; the trust itself is the legal owner of the stock. Within the trust, stock is allocated to employees’, or participants’ accounts. Over time, the number of shares allocated to an employee’s account increases and typically the value of the stock itself increases. When employees leave the company, they are able to sell the stock in their accounts.

There are generally two types of ESOPs:

  • Nonleveraged (no debt)
  • Leveraged (includes debt or borrowing)

A leveraged transaction is the most common whereby the ESOP borrows money in order to buy stock from the selling shareholders. Over time that stock is allocated to participants as the loan for that borrowing is paid down. In a nonleveraged setting, the company is contributing cash to the ESOP and the ESOP buys company shares, or the company contributes shares directly into the ESOP.

Approximately 10,000 ESOPs have been formed in the United States covering 10.3 million employees, according to statistics from The ESOP Association. Half of those are majority-owned by the ESOP, meaning the selling shareholders have sold more than half of their investment of stock in their companies; and 4,000 of those 5,000 are 100 percent-owned.

Exit Strategy

ESOPS are a popular exit strategy for many company owners. While there are pros and cons with an ESOP just as there are with other exit strategies, most companies are suitable candidates. In the end, it comes down to the selling shareholders deciding if this is something they want to pursue and considering all their options. There are ESOPs in all types of industry, but the top three include manufacturing, construction and related companies, and professional services such as engineering.

Many business owners have their personal wealth tied up in the company. As they look to diversify, one option is selling all or a portion of the business to an ESOP, hence creating a liquidity event and a powerful succession-planning tool. The ESOP also provides retirement proceeds to participants that often exceed those of traditional plans, such as a 401(k). In fact, it isn’t uncommon for the benefit to be more than double that of a traditional retirement plan.

In addition to an ESOP, here are other traditional exit strategy options:

  • Transferring ownership to the next generation
  • Selling the company to management
  • Selling to a financial buyer, such as a private equity firm
  • Selling to a strategic buyer, such as a publicly traded company

Benefits

As an incentive for companies and their shareholders to continue utilizing an ESOP or to consider using it as an exit strategy, Congress created income tax advantages for companies and their shareholders.

There are two significant tax benefits afforded ESOPs:

  • First, the ability of the corporation to deduct the principal paid on the loan that was incurred for the ESOP to buy the stock held by the ESOP. This is, in effect, a tax advantaged leverage buyout.
  • Second, though only currently for C-corporation shareholders, the owner’s sale of stock to the ESOP can be structured to be tax deferred. These benefits were designed to give employers an incentive to encourage employee ownership in the company. Furthermore, employee ownership can enhance employee productivity and company performance.

Under current law, a 100 percent ESOP-owned S corporation pays no federal income tax. (Many state income tax regimes yield the same result, but since the rules are state specific, you’ll want to verify your situation.) This makes it easier for the company to service the debt, thus reducing risk in a leveraged transaction compared to a traditional leveraged buyout. It also results in the underlying equity in the company increasing at a faster rate than would have otherwise been the case since the company isn’t paying federal (and likely state) income tax on its earnings.

Employee Benefits

For employees, there are typically both monetary and nonmonetary benefits.

Anecdotally, contributions to ESOPs seem to exceed those of traditional retirement plans. Keep in mind that employees typically don’t have to contribute money to an ESOP. Employees are participating in economic ownership of the company and getting a valuable retirement benefit at no cost to themselves.

Monetary benefits for employees in an ESOP:

  • Economic ownership in the company
  • An appreciation in the equity of the company over time
  • Taxes aren’t paid on this benefit until a distributional event such as diversification, retirement, or termination

Nonmonetary benefits:

  • A sense of ownership and pride
  • Increased productivity and job satisfaction related to that sense of ownership
  • More job security

The shares are typically allocated to participants based on compensation. So an employee who makes $200,000 a year will get a higher percentage of that stock than an employee who makes $20,000 a year. Participants receive an annual statement showing the amount of shares allocated to them that year as well as the value of their entire account balance—just like they would in a profit-sharing plan.

There are also vesting provisions you can include in the ESOP. There are typically two types of vesting:

  • Graded vesting, which might be 20 percent per year with participants fully vested after six years.
  • Cliff vesting, which is when employees have no vested interest in their account until they’ve been employed for three years—similar to profit-sharing or 401(k) plans—at which time they are 100 percent vested.

Retirement Strategy

An ESOP is a great exit strategy with some fantastic tax benefits, but it’s also a retirement benefit for your employees. As employees near traditional retirement age, they must also be offered diversification options in order to avoid the risk of having all their eggs in one basket. As an employer, you must look at this as you look at your total rewards package. Ask yourself these questions:

  • Who are you competing with in the labor pool?
  • What’s the end benefit that you would like to provide to your employees?
  • What do they need in order to retire?
  • What does the total rewards package look like in your company?
  • What value do your employees place on deferred compensation versus immediate gratification in a bonus or commission structure?

An ESOP is considered qualified under the internal revenue code for tax deferred retirement benefits. This is how it works: The employer makes contributions to the plan, participants are allotted a portion of the contribution each year, and when they retire they can realize that value, pay tax on it, and take their money for retirement. If you have an ESOP retirement plan, you can still have your 401(k) plan or your pension plan on the side.

Suitable Candidate?

Since most ESOPs are leveraged, your company needs to be financially strong with a balance sheet that has the capacity to take on additional borrowing, cash flow, and earnings to support that debt. As for size restrictions, there are some practical limitations. ESOPs tend to work best for companies that have at least 20 employees and revenue of $5 million or more.

Since the primary purpose of an ESOP is to own employer securities, the ESOP is an option for C and S corporations only. Companies organized as a limited liability company would have to convert into a corporation, which can create significant tax implications.

As is the case with any exit strategy, you’ll also want to have a competent management team, not only with experience, but also with depth so that one person doesn’t have all the relationships with your suppliers or with your customers. It wouldn’t be ideal if that one person, whether a sales person or a shareholder, left the company and put its future at risk. Incentive stock options or stock appreciation rights are common to help retain key individuals.

Establishing an ESOP

Once you’ve established your company is a suitable candidate, you can begin setting up your ESOP. In simplistic terms, a company creates an ESOP trust that oversees the plan. The ESOP then buys the owner’s shares at a fair market value. The selling shareholder receives one or a combination of cash and a seller note with interest paid to the owner at prevailing market rates.

During the process of establishing an ESOP, there are a few steps to consider:

  • Conduct a feasibility study
  • Communicate with your accountant, banks, and other stakeholders
  • Engage your trustee and attorneys

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Participants are relying on their allocated shares for retirement, and although third-party administrators can help manage and track day-to-day operations of the ESOP, it’s ultimately the plan’s fiduciary that’s responsible for procuring a high-quality valuation and audit.

If the benefits are communicated effectively and there’s employee involvement, then there are typically positive results with ESOPs, whether it’s an increase in sales, profit, longevity of the company, employee wages and compensation, or retirement benefits—it’s a winner in all aspects and a fantastic way to reward and incentivize participating employees. It’s also important your plan is administered in accordance with the IRS, Department of Labor, and Plan Document.

If you’d like to learn more about whether an ESOP is right for your company and how to set it up, contact your Moss Adams professional.