When facing a business transition, business owners have a variety of options that include a sale to outside or inside parties. A sale to inside parties can be achieved through a direct sale, or through the use of an Employee Stock Ownership Plan (ESOP). For business owners without an established succession plan, ESOPs are an excellent way to transfer ownership to the next generation without the employees having to purchase it outright.
In this article we will discuss the basics of an Employee Stock Ownership Plan, why it may be implemented, and what makes it different from other benefit plans.
An ESOP is a tax-deferred employee benefit plan designed to invest in the stock of the employing company,In an ESOP, a company establishes a trust and either contributes shares or cash to buy existing shares of stock from selling shareholders (a Non-Leveraged ESOP). Alternatively, the ESOP can borrow money to buy the shares (a Leveraged ESOP). If the ESOP borrows money, contributions from the company are used to repay the debt. In either case, contributions to the ESOP are tax-deductible, within certain limits. In the case of a Leveraged ESOP, shares are allocated to employee accounts as the debt is repaid. Over time, employees accumulate account balances and their shares typically begin vesting after one year of service.
When an employee departs or retires from the company, they are entitled to receive the fair market value of their vested shares as determined by a third-party appraiser. Distributions from the ESOP may be made in a lump sum or through installments and may be immediate or deferred. While an ESOP is designed to invest in the stock of the employing company, employees can roll their ESOP distributions over to another qualified plan and are not taxed until they actually receive the distributions. As employees approach retirement, eligible employees that meet certain requirements can request that up to 50% of the stock in their account be diversified into other investments.
An ESOP is intended to benefit employees that have remained with the company for a long period of time and have contributed to the success of the company. As a result, an employee’s retirement assets can grow significantly as his or her tenure with the company increases and if the employer’s stock appreciates in value. Because stock is allocated to each employee’s account based on contributions from the company, the employee does not incur any direct costs.
Determining the number of shares to sell to an ESOP depends on several factors, including the overall goal of the business and the selling shareholders. The business owner and ESOP trustee will determine the amount of stock to be sold and the terms of the sale, based on a third-party appraisal of the company’s value.
Companies that implement ESOPs commonly do so to facilitate an owner’s retirement plan, monetize illiquid assets, or motivate an employee base by linking employee benefit to company performance, while also providing a number of beneficial tax advantages to both the owner and the company.
An ESOP can be beneficial for both owners and employees, but it must be thoughtfully executed to reap the most benefits. This section highlights some of the reasons business owners enter into ESOP transactions.
- Liquidity: In many instances, the owner of a privately held business has a significant portion of his or her wealth tied up in their business. Some industries or companies are not conducive to other liquidity strategies due to a lack of interested buyers. However, many of these businesses are profitable and possess strong competitive positions in their local or regional markets. An ESOP creates a ready market for their stock. Moreover, a shareholder selling their stock to an ESOP sponsored by a C-corporation may be able to defer capital gains tax on the sale, as described below.
- Tax Deferral: A shareholder selling stock to an ESOP sponsored by a C-corporation may be able to defer capital gains tax on the sale indefinitely under Section 1042 of the Internal Revenue Code (1042 Rollover). In order to qualify for a 1042 Rollover, the seller must have held the stock for at least three years, the ESOP must own at least 30% of the total stock immediately following the sale, and the seller must reinvest the proceeds into qualified replacement properties (QRP) within a 12-month period following the sale. QRP is defined as stocks and bonds of United States companies. Long-term capital gains are recognized upon the liquidation of the QRP securities at a future date. If the QRP is not liquidated and becomes an asset of the seller’s estate, it enjoys a stepped-up basis and avoids capital gains tax entirely.
- Tax-Deductible: Contributions, whether in the form of stock or cash, are tax-deductible, within certain limits. In general, companies can deduct up to 25% of the aggregate compensation of employees in the plan. ESOPs are also unique in that they can borrow money. In a Leveraged ESOP, the ESOP borrows cash, which it uses to buy company shares from existing owners. The company then makes tax-deductible contributions to the ESOP, which in turn repays the loan. In the case of an S-corporation, the ESOP’s share of earnings is tax-exempt. Tax deductions or exemptions enhance a company’s cash flow and provide opportunities for growth through acquisition, capital investments, or other means.
- Ownership Transition: By creating an ESOP, an owner can monetize illiquid stock assets without selling the whole company. The ESOP can be used as an intermediate or long-term exit strategy, with sales structured in one or more tranches. Thus, an ESOP enables owners to remain involved in the business if desired and facilitates a smooth transition for company management.
- Business Continuity: Business owners have a variety of options when planning their exit strategy, such as an initial public offering, a sale to a strategic or financial buyer, a sale to management, or some combination of these. Outside buyers are often poorly equipped to see the value and vision of a company, while selling to an ESOP provides for continuity in the company’s workforce and operations.
- Employee Motivation and Retention: For an employee, an ESOP can be an effective retention tool because of the clear benefit it provides the employees. Because an ESOP aligns the interest of employees, studies have shown that ESOPs generally incentivize employees and improve performance.
As a qualified employee benefit plan, an ESOP is designed to provide retirement benefits to employees, and in some regards is similar to that of other retirement benefit plans. Aside from some basic similarities, ESOPs are considerably different. Highlights of some of the key differences between ESOPs and other retirement benefit plans include the following:
- An ESOP is permitted to borrow funds on employer credit in order to acquire employer stock, providing significant flexibility for a company.
- While contributions to other retirement plans are also tax-deductible, ESOPs have substantial additional tax benefits, including the ability of sellers to defer capital gains taxes under certain scenarios, the ability to use dividends or distributions to increase contribution limits, and in the case of S-corporations, not paying income tax on the proportion of ownership attributable to the ESOP.
- Unlike a 401(k) plan where contributions are used to invest in a variety of outside stocks, bonds, and mutual funds, an ESOP invests in the stock of its employer. However, employees aged 55 and with 10 years in the ESOP plan must be allowed to diversify a total of 50% of company stock over six years.
- Employees become owners of their employing company and participate directly in its growth and success. As a result, an ESOP aligns the interests of management and employees and often leads to improved productivity, retention, and profitability.
An ESOP is an attractive employee benefit and corporate financing tool, with numerous advantages as highlighted in the preceding sections.. While business owners have a variety of options when facing a business transition, an ESOP combines financial advantages with the flexibility that enables a business owner to customize the sale to fit their circumstances.