Frequently Asked Questions
General Questions
Complexity is a commonly cited concern, and it’s easy to understand why. An ESOP isn’t just an exit strategy; it’s also a qualified retirement plan subject to regulation by the Internal Revenue Service and Department of Labor under the Employee Retirement Income Security Act of 1974 (ERISA). That means there are required documents, regular filings, and rules that must be strictly followed.
But the same could be said of virtually any other means of transitioning business ownership. A third-party sale may involve broker fees, myriad legal and financial documents, valuation and appraisal, contracts, corporate resolutions, non-compete agreements, contingencies, and much more. Transactions can come down to the wire or collapse before completion. And finally, third-party sales miss out on significant ESOP tax advantages — lowering net value to the seller in the big picture.
In general, business transactions are often complex and involve a certain level of risk. But working closely with a trusted team of ESOP experts enables your team to address and mitigate ESOP risks, so you can move forward with clarity and confidence.
The misconception here is that the consulting, valuation, and administrative costs are prohibitive. Yet 5,866 closely held or private corporations have ESOPs. While most new ESOPs are 100% employee owners, even more existing ESOP companies are partially (not 100%) owned by the ESOP trust. This shows that even those minority-held ESOP companies find the plan’s ROI justifies their ESOP-related expenses.
At the same time, ESOPs pay wages equal to or higher than market averages, and often better benefits, as well. This is all evidence to suggest that an ESOP’s advantages can (and very often do) outweigh the costs.
By and large, ESOP-owned companies outperform their non-ESOP counterparts. They weather shocks (like recessions and pandemics) better. They experience lower levels of employee turnover, a costly problem for many businesses today.
Ultimately, it’s important to remember that every ownership transition strategy comes at a cost—and not all exit strategies have the same potential as an ESOP to support long-term business growth.
No, employees are not required to invest their own money to buy ESOP shares, although the ESOP company may offer employees the option to purchase additional shares through payroll deduction or other method. In an Employee Stock Ownership Plan (ESOP), a company sets up a trust fund into which it contributes new shares of its own stock or cash to buy existing shares on an annual basis. These shares are then allocated to individual employee participants’ retirement accounts as a benefit of employment.
Most ESOP allocation formulas distribute shares in proportion to employee compensation, so higher-paid employees receive a higher percentage of the year’s contribution than lower-paid employees. Deference is given to Internal Revenue Code Section 401(a)(4) requirements that prevent ESOPs from disproportionately benefiting highly compensated employees (HCEs).
Allocation formulas may also take employee tenure into account. Some ESOPs are designed to allocate shares in rate groups or some other formula to achieve more equal allocation, but the allocation formula is part of the plan design, which is subject to IRS review and determination.
ESOPs aid in the gradual transfer of ownership to employees. Selling owners can phase out at a controlled pace to ensure business continuity, protect legacy and culture, as well as leverage tax advantages and liquidity flexibility.
For employees, being made owners is often a catalyst for enhanced motivation, productivity, and loyalty — which benefits everyone.
An ESOP is a qualified retirement plan, which is a tangible benefit prospective employees can appreciate. Yet, it’s the intangibles that often sell them on working at an employee-owned company.
ESOPs offer a unique wealth-building opportunity. The number of shares generally increases over time, and company performance can increase the value of those shares. As the company’s stock price rises, so does employees’ individual retirement wealth — and employees can influence their personal financial success by helping the company consistently perform to goals and grow profitability.
In addition to financial rewards, ESOP cultures give employee owners a valued voice in the company. Being recognized can translate to higher job satisfaction, which is often important to job candidates. Emphasizing how ESOPs generally experience lower turnover rates and are invested in preserving local jobs can instill a sense of confidence and stability in how prospective employees view your employer brand.
Collectively, these factors help underscore a position at an ESOP company being more than a job; it’s a career investment that encourages a deeper commitment to the long term success of the company and its employee owners.
Overall, ownership culture helps create a team of employee owners who are motivated, engaged, and committed to company performance and results. The sense of ownership can cultivate a more positive and collaborative work environment, higher job satisfaction levels, and confidence in greater job security, stability, and retirement readiness.
In turn, companies that implement ESOPs and foster ownership culture benefit from improved productivity and efficiency. There’s also the greater likelihood of employees with ownership stakes remaining at the company — a corporate and competitive advantage in the tight labor market.
The mutual benefits of ownership culture elevate the intrinsic value of ESOPs. Employees gain financial security and a sense of valued belonging, while the company gains the advantages of a dedicated team focused on the company’s success.
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Sales & Financing
Transferring ownership to employees through an ESOP helps keep a company’s legacy and culture intact. It also eliminates the potential for external restructuring or downsizing that could adversely affect operations and employee longevity.
Transactionally, ESOPs are based on federally regulated fair market value, whereas a third party sale may be conditioned on factors such as expected financial returns. Fair market value provides a balanced approach that considers the interests of both the selling owner and the employees.
Selling a company to an ESOP starts with establishing a trust that will hold the company shares on the employees’ behalf. Financing the purchase requires the selling owner to put up company assets to secure a loan from a bank or other lender, commonly referred to as leveraged financing.
The borrowed money is then loaned to the ESOP trust to fund purchase of shares at fair market value. The transaction transfers ownership of the shares from the selling owner to the trust, and ultimately to the employees.
Over time, the company makes tax-deductible contributions to the ESOP trust, and the trust uses the contributions to repay the loan. Allocation of shares to employees is done in proportion to the loan balance as it is paid off.
The combination of bank financing and company contributions to the trust transfer ownership to employees over time, without any upfront financial investment.
Establishing fair market value for the business for the company determines the ESOP company stock price.
The company stock price is determined on an annual basis by an independent appraiser, as required under Internal Revenue Code Section 401(a)(28)(c). An independent ESOP valuation professional uses one of several valuation methods to arrive at company valuation, commonly capitalization using discounted cash flow, multiples of EBITDA, or the asset approach.
The Internal Revenue Service (IRS) defines “fair market value” as a company valuation standard that identifies a price at which the sale transaction would take place between a buyer and seller in which neither party is under compulsion to buy or sell. In addition, arriving at fair market value assumes that both parties to the sale have reasonable knowledge of the relevant details affecting company sale price.
The percentage of stock that an ESOP should acquire is flexible. It can vary based on the company's goals and the specifics of the transaction. Some companies might initially engage in a partial sale, with the ESOP ownership percentage increasing over time.
However, there are some common guidelines. C corporation ESOPs must acquire at least 30% of company stock to trigger certain tax benefits. While 30% is the minimum, it’s common for ESOPs to hold 50% or more in order to optimize employee ownership.
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Taxes
ESOP income tax exemption only applies in very specific circumstances. In most cases, a 100% ESOP-owned S corporation is not subject to federal income tax, and is usually also exempt from state income tax.
It’s a powerful tax advantage that warrants close attention since, over time, the ESOP tax benefit can significantly offset costs associated with the ESOP sale and ongoing administration.
Likewise, tax savings can provide needed cash flow for an ESOP to purchase a company from the selling shareholder(s). Once the stock purchase has been fully funded, the cash flow resulting from the tax benefit provides a company with a cash flow competitive advantage over their non-ESOP counterparts.
The loophole theory is a widely held belief, but it’s inaccurate. ESOP tax benefits are intentional, not a consequence of an IRC oversight error. In fact, ESOP tax benefits are cited in legislation, specifically the Small Business Job Protection Act of 1996 and the Taxpayer Relief Act of 1997 and IRC §512(e).
Congress considers selling to an ESOP to be good public policy and created this benefit to further incentivize ESOPs and employee ownership. Studies demonstrate better performance, higher compensation, and other positive outcomes in ESOP companies which may increase wealth distribution and decrease the number of people reliant on government-funded entitlement programs.
Primarily, companies realize several tax advantages by implementing an ESOP. Company cash or stock contributions to the ESOP are tax-deductible, which can reduce taxable income and increase tax savings. Loan repayment in this manner also allows the company to finance the buyout using pre-tax dollars.
C corporation shareholders can defer capital gains taxes on stocks sold to the ESOP as designated by the IRC, as long as the ESOP owns at least 30% of the company and certain other conditions are met. For S corporations, some of the company earnings going to ESOP ownership shares are exempt from federal income tax, up to 100% of ESOP ownership of an S corporation.
Employees who participate in an ESOP receive several tax benefits that can help them build retirement savings by deferring taxes and possibly lowering capital gains tax rates on ESOP share growth.
Employees don’t pay taxes on contributions made to the ESOP until they start receiving distributions, meaning ESOP account values grow on a tax-deferred basis. ESOP distributions are taxed at standard income tax rates. Any appreciation on sales of ESOP shares may be subject to capital gains tax, often at rates lower than that of ordinary income.
In some cases, tax deferrals may be maximized by rolling over ESOP distributions into an IRA or other qualified retirement plan. Taxes don’t apply until the new plan distributions start.
Structure
- Creating an ESOP trust to hold shares of company stock and is managed by a trustee who acts in the employees’ best interest
- Contributing shares of company stock or cash to the ESOP trust for buying existing or new shares that are issued directly to the trust
- Allocating shares in the ESOP trust to individual employee accounts, usually based on employee compensation or years of service
- Determining vesting schedule that outlines the amount of time employees will earn ownership of shares, which can be any length of time but is commonly three to five years
- Securing financing that may mean the company borrowing from a bank or other lender using company assets as collateral (leveraged ESOP) with the loan repaid over time, or the company directly contributing shares or cash to the ESOP without borrowing (non-leveraged ESOP)
- Distributing the value of shares to employees who retire or otherwise separate from the company, with the company either repurchasing the shares or providing the cash equivalent to share value
Every situation is different and any number of factors can affect the timeline to completing key steps in an ESOP setup. Typically, the process takes between 6 and 12 months, broken down as follows:
- (1 to 2 months) Initial feasibility study to assess ESOP viability and have ESOP consultants evaluate the company financials and readiness for moving forward with a plan
- (1 to 2 months) Designing the ESOP with guidance from financial advisors and legal professionals as to percentage of ownership transfer, vesting schedule, and other plan details
- (1 to 2 months) Company valuation using an independent valuation firm for accurate and compliant determination of fair market value and the price of the shares transferred to the ESOP
- (1 to 3 months) ESOP financing and structure, which may involve securing loans for leveraged ESOPs, and finalizing terms with lenders
- (1 to 2 months) Legal document preparation including formal plan documents, trust agreement, and other instruments as identified by ESOP attorneys and ensuring all documentation complies with ERISA and IRS regulatory requirements
- (1 to 2 months) Obtaining approvals for the ESOP from the board and, if necessary, from shareholders; file documentation with the Department of Labor and IRS
- (1 to 2 months) Plan implementation that includes setting up the ESOP trust and transferring shares or cash to it, along with rolling out a communication plan to educate employees about the ESOP
Designated fiduciaries are legally obligated under ERISA to handle different aspects of the ESOP.
The ESOP Trustee oversees the ESOP and impartially acts in the best interests of employees, which includes valuing company shares and making sure the ESOP remains in legal compliance.
ESOP Plan Administrators may be individuals or committees, responsible for managing day-to-day ESOP operations, ensuring compliance with regulatory requirements and overall health of the ESOP.
An independent ESOP Appraiser is responsible for establishing the annual ESOP stock price, verifying fairness of the valuation, and protecting employees’ interests.
When the appointed fiduciaries carry out these responsibilities, they protect the ESOP’s integrity and long-term viability.
No, with a caveat. Commonly, ESOP companies have certain plan eligibility criteria in place that may preclude certain employees from participating. On the other hand, some ESOP companies automatically enroll all employees as plan participants.
However, the ESOP must be structured to fairly include all employees who meet eligibility and vesting thresholds. To do so, a plan must establish eligibility criteria such as minimum age or minimum service period; comply with IRS nondiscrimination rules to preclude unfair favoritism toward highly compensated employees; and, define vesting requirements based on length of service that detail how and when employees have full ownership of ESOP share allocations.
Annually, the ESOP-owned company can contribute shares to the plan, the ESOP trust can purchase company stock using cash in the plan, and/or shares can be released from a suspense account as loan payments are made throughout the year prior to the allocation date.
Those shares are then allocated by the plan to eligible employees’ individual retirement plan accounts, typically based on the amount of each employee’s eligible compensation. Internal Revenue Code (IRC) minimum coverage requirements outlined in Section 401(a)(4) prevent ESOPs from disproportionately benefiting highly compensated employees (HCEs).
When employees retire or leave the company, the fair market value of their ESOP shares are paid to them through a distribution process. Distribution may be handled through a lump-sum payment or installments, each of which have tax implications based on ordinary income taxation triggered by the distribution. In some instances, employees may choose to rollover their ESOP distribution into an IRA or other qualified retirement plan which defers taxes until distributions are drawn on the new plan.
Governance
Employees have an ownership stake in the company, but that stake does not trigger participation in company decision making. In terms of corporate governance, ESOP companies determine their own rules around the amount and level of employee involvement.
The ESOP Trustee acts on behalf of the employees, while board and leadership decisions are the responsibility of the board of directors and executive leadership. Employees may be asked for input and encouraged to have their voices heard through surveys, listening sessions, and employee committees.
Employee owners are not entitled to full corporate financial disclosure, but companies must meet specific disclosure requirements regarding the ESOP:
- Annual disclosure of ESOP share value and the plan’s financial status summary
- Minimal financial information that excludes detailed financial statements, salaries, or granular data on the company’s financial status
- ESOP Fiduciary Duty that allows Trustees and other ESOP fiduciaries to access financial information necessary to comply with their obligations to plan management and representation of employees
Talk to our experts and see if the benefits of an ESOP are right for you.
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