Closing the income inequality gap has been a hot topic on both sides of the aisle for many years. Perhaps more impactful to the long-term sustainability of our democracy is closing the wealth inequality gap. Half of the working age population have no retirement savings, and 20% have no wealth at all. Few deny that a wealth gap exists, but disagreement abounds around how to best solve the issue. While many focus on legislative solutions, a solution to help working Americans build wealth through their everyday efforts, the Employee Stock Ownership Plan (ESOP), already exists. It’s also a strategy that helps build better-performing companies.
Congress laid out the guidelines for implementation of the ESOP in the Employee Retirement Income Security Act of 1974 (ERISA). Now, nearly 50 years later, more than 7,000 U.S. companies are employee owned, and millions of employee owners have built wealth through ownership of the companies they work for that they never could have built through other means.
Recent research by the Employee Ownership Foundation and the Rutgers School of Management and Labor Relations indicated that a large majority of working Americans surveyed would prefer working for an employee owned firm – including support from 74% of Democrats, 72% of Republicans, and 67% of Independents surveyed. It is challenging to envision another government program with such enthusiastic support from across the political spectrum.
With all that said, it is not hard to see why ESOPs still appeal across the board. It’s a tax-deferred way for a business owner to realize liquidity, a vehicle to drive corporate performance, and a tax-deferred retirement plan for employees all rolled into one.
How Does an ESOP Work?
In forming an ESOP, a company will establish a trust for the benefit of the employees which then purchases some or all of the stock from the company’s existing owners. This allows the owners to achieve liquidity while maintaining company culture, and with the proper structure, realize a significant tax advantage.
The purchase of company stock may be financed in various ways, but a key tenet is that employees are not typically making any personal contribution. As such, employees are able to acquire ownership in a company without expending the capital required in a traditional transaction.
Participants in the ESOP will generally receive allocations of company stock over time based upon annual tax-deductible contributions to the trust by the plan sponsor. Upon separation or retirement, the employee owner will have his or her stock purchased by the trust or company, and then can realize this newfound liquidity or roll the proceeds into another tax-advantaged retirement vehicle such as a 401k plan or IRA. Overall, employee owners can think of an ESOP as being similar to a 401k plan, except no employee contributions are required and employee efforts directly influence the performance of the company and thereby impact the stock price.
How Do Employee Owners Benefit from an ESOP?
Employee-owners benefit most from an ESOP when they are employed for a significant amount of time such that they can realize years of annual allocations compounded by appreciation in company stock. This benefit is not taxable to the employee owner until distributions are received at retirement or separation, allowing the participant to benefit from years of tax deferrals.
These benefits to employee owners are perhaps best viewed by actual results. According to a survey conducted by the EOF in conjunction with Rutgers University, an average employee in an ESOP-owned company had an account balance of $134,000, compared to the average 401k balance of $103,700. Additionally, a 2017 study by Nancy Wiefak of the National Center for Employee Ownership showed that millennials that were participants in ESOPs had a median household net wealth that was 92% higher than non-employee owners. Further, a 2019 Rutgers University study concluded that ESOP plans significantly increased assets for families and assisted in shrinking racial wealth gaps. With an ESOP, the proof is in the pudding.
What are the Tax Benefits of an ESOP?
Historically, ESOPs have been incentivized via tax benefits to the sellers, company, and employee participants. These benefits include potential deferral or avoidance of tax on capital gains, the deductibility of employer contributions and dividends, tax-free ownership for ESOP owned S corporations, and tax deferral for gains realized by employee participants. When properly structured, business owners who elect and comply with the provisions of Internal Revenue Code section 1042 can even defer taxes on the proceeds of a sale to an ESOP indefinitely. The specifics of the various tax advantages are beyond the scope of this article but are detailed in ESOP Tax Advantages and Benefits .
How Do ESOP Companies Perform?
ESOP companies not only offer tax benefits to business owners and retirement benefits to employee-owners; they also tend to have better performance than comparable non-ESOP businesses. According to a 10-year study conducted by Joseph Blasi and Douglas Kruse of Rutgers University, privately held ESOP companies went bankrupt at a rate half of that of comparable non-ESOP companies and were slower to lay off workers in a downturn. Further, ESOP companies tended to have better sales & employee growth relative to non-ESOP companies in the period after adopting the ESOP. While ESOPs are not necessarily a panacea for underperforming firms, when combined with proper communication, implementation, and execution, can serve as an effective tool in driving an ownership culture amongst employees.
According to a study by Wilmington Trust, 58% of small business owners do not have a succession plan and the majority of small business owners’ primary wealth is tied up in their business. With the end of the Covid-19 pandemic in sight, business owners are beginning to realize that exit planning is of the upmost priority. Despite the bipartisan support for employee-ownership, many of these small business owners do not realize that an ESOP could help them achieve their goals while maintaining company culture and generating wealth for employees who were critical in the success of their firm. At the same time, this can all be accomplished on a tax advantaged basis.
Rather than attempting to close the wealth gap through taxes or some other untested government action that attempts to forcibly redistribute wealth, we believe that a better approach is to help wage earners accumulate wealth through the ownership of productive assets. We can think of no better asset for workers to accumulate than an interest in the company they work for. What other strategy affords a person the ability to accumulate assets without an out-of-pocket investment, and at the same time impact the value of that asset each and every day? The answer, of course, is an ESOP, a concept with a proven track record that was already enacted by Congress nearly 50 years ago.