Discover How ESOPs Work and How They Can Benefit Business Owners and Employees

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

Below, learn how an ESOP works as well as key benefits and common questions.

What’s the Definition of an ESOP?

The objective of an ESOP is to provide retirement benefits to 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’re able to sell the stock in their accounts back to the company.

There are generally two types of ESOPs:

  • Nonleveraged. The company contributes cash to the ESOP and the ESOP buys company shares, or the company contributes shares directly into the ESOP.
  • Leveraged. The ESOP borrows money to buy stock from the selling shareholders. Over time, that stock is allocated to participants as the loan for that borrowing is paid down.  This option is the most common.

As of 2018, approximately 6,500 ESOPs have been formed in the United States, holding total assets of over $1.4 trillion, according to statistics from The National Center for Employee Ownership. ESOPs cover over 14 million participants, of whom 10.3 million are active participants, meaning they’re currently employed and covered by an ESOP.

How Can an ESOP Work as an Exit Strategy?

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

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, which creates 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

Learn more about how to prepare for an exit and help protect your financial future in our article.

What Are the Benefits of an ESOP?

Tax Benefits

To incentivize companies and their shareholders to continue utilizing ESOPs or consider using them as an exit strategy, Congress created various tax benefits for companies and their shareholders.

There are three significant tax benefits afforded ESOPs:

  • Tax-advantaged leverage buyout. Congress provided the ability for a corporation to deduct the principal paid on the loan that was incurred for the ESOP to buy the stock held by the ESOP.
  • Allowance of tax deferral. The owner’s sale of stock to the ESOP can be structured to be tax deferred; however, this is currently only available for C corporation shareholders.
  • Federal income tax. Under current law, a 100% ESOP-owned S corporation pays no federal income tax. This makes it easier for the company to service the debt, thus reducing risk in a leveraged transaction compared to a traditional leveraged buyout.

An ESOP also results in the underlying equity in the company increasing at a faster rate because 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.

Generally, contributions to ESOPs seem to exceed those of traditional retirement plans. Employees also typically don’t have to contribute money to an ESOP—they’re participating in economic ownership of the company and getting a valuable retirement benefit at no cost to themselves.

Monetary Benefits
  • 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 or retirement
Nonmonetary Benefits
  • Heightened sense of ownership in the company’s success, and how employees contribute to this
  • Increased productivity and job satisfaction related to that sense of ownership
  • Greater employee retention
  • Increased business literacy; employees gain insight into how the company’s performance is tied to its value

Learn how an ESOP can lead to more productive, satisfied employees in our article.

How Are ESOP Shares Allocated to Participants?

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 number 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, where a defined percentage is vested every year for a set time period. For example, it might be 20% per year with participants fully vested after six years.
  • Cliff vesting, which occurs when employees have no vested interest in their account until they’ve been employed for a defined amount of time, for example three years, after which they’re 100% vested.

Participants receive the vested portion of their ESOP accounts after job termination, retirement, or death. Benefit distribution practices can vary, but they’re generally paid in equal installments over five years. However, other options, such as lump sum payments or a delay in distributions, are permitted depending on the design of the plan.

How Can an ESOP Work as a Retirement Benefit?

An ESOP is considered qualified under the Internal Revenue Code (IRC) for tax-deferred retirement benefits. The employer makes contributions to the plan, and participants are allotted a portion of the contribution each year.

When participants retire, they can realize that value, pay tax on it, and take their money for retirement. If an employee has an ESOP retirement plan, they can still have a 401(k) plan or a pension plan as well.

Another benefit of an ESOP is the ability for participants to diversify their investment in the plan as they near retirement age. Generally, participants that have reached the age of 55 and have participated in the plan for ten years are eligible to make a diversification election, which allows them to exchange a portion of their company stock for cash or other investments.

This helps to mitigate financial risk to the participant by allowing them to invest their retirement savings in more than one company, similar to avoiding the risk of having all of your eggs in one basket.

Business owners considering ESOPS should consider their competitive benefits as an employer:

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

What Types of Organizations Are Suitable Candidates for an ESOP?

Because most ESOPs are leveraged, your company needs to be financially strong with a balance sheet that has the capacity to take on additional borrowing. It must also have the 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.

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

As is the case with any exit strategy, you’ll also want to have a competent, diversified management team. The team should be experienced and large enough that one person doesn’t have all the relationships with your suppliers or customers. It wouldn’t be ideal if that one person, whether a salesperson 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.

How Do You Establish an ESOP?

Once you’ve determined your company’s a suitable candidate, you can begin setting up your ESOP. In simple 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 cash, a seller note, or a combination of both with interest paid to the owner at prevailing market rates.

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

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

How Do You Account for an ESOP?

ESOP companies have specialized accounting under the Financial Accounting Standards Board (FASB) Accounting Standards Codification (ASC) 718-40, Employee Stock Ownership Plans.  Under the codification, as a leveraged ESOP company, the debt of the ESOP is recorded as a liability, and the shares purchased as a contra-equity account until those shares are no longer used for collateral on the borrowing. 

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Explore our complimentary tools and articles for more information about other benefit plan resources as you begin this journey.

To learn more about whether an ESOP is right for your company or how to get started, contact your Moss Adams professional.