Employee ownership can be an attractive option for owners looking to sell their business while maintaining their legacy and protecting the wellbeing of employees. The following article answers common questions related to the creation, financing, valuation and tax benefits of employee stock ownership plans (ESOPs).
An ESOP — employee stock ownership plan — is a tax-qualified, broad-based, workplace retirement plan (similar to a 401(k) plan), that allows current and future employees to receive beneficial ownership in the company over time, which grows tax-free until paid out. Unlike a 401(k) plan, however, employees typically are not required to contribute to the ESOP. To get the special tax treatment, ESOPs must invest primarily in employer securities. ESOPs are also subject to the Employee Retirement Income Security Act of 1974, as amended (ERISA), which sets out fiduciary obligations and other protections for plan participants. ERISA requires that the ESOP’s assets be held in a trust, which is a separate legal entity from the employer.
In addition to providing retirement benefits for employees, an ESOP can be used as an exit or liquidity vehicle for the owner(s) of the company and can provide tax benefits to both the company and the selling shareholders, as well as an additional retirement benefit for employees.
An ESOP can be either non-leveraged or leveraged. In a non-leveraged ESOP, shares or cash (which can later be used to purchase non-ESOP shares from the sellers) are contributed to the ESOP. Once contributed, the shares or cash is allocated to employees’ accounts based on their salary, tenure, or a combination of both. The company receives a tax deduction for the fair market value of the shares or the cash contributed to the plan, subject to limits.
An ESOP is the only tax-qualified retirement plan in the U.S. that can borrow money. This allows for a leveraged ESOP transaction. In a leveraged ESOP, shares of stock are purchased by the ESOP trust with a note from either the company or the selling shareholders. The shares purchased with the note are held as collateral for the loan in a suspense account within the ESOP. As the note is repaid, unencumbered shares are released to the employees’ ESOP accounts. The note repayment is tax-deductible, subject to limits. The shares in the employees’ ESOP accounts will typically be subject to vesting, similar to the ERISA vesting rules that apply to an employer’s contributions to a 401(k) plan. When an employee leaves the company, typically, the employee is paid for his or her shares, either in a lump sum or over several years.
In both scenarios, the employee is the beneficial owner of those shares (and thus receives benefits from the shares), whereas the ESOP trust legally owns the shares (so the ESOP trust counts as only one shareholder, regardless of the number of ESOP participants). The trustee has a fiduciary duty to protect the employees’ retirement benefit. The ESOP trustee does not insert themselves into the day-to-day operation of the business, nor do they typically sit on the board of directors. Instead, their role is to ensure that any corporate action taken is in the best interest of the employees.
The biggest difference between the two plans is the out-of-pocket cost to the employee. In a 401(k) plan, employees make pre- or post-tax salary deferrals, and employers may also contribute to the plan. Many ESOP-owned companies will retain the existing 401(k) plan and may or may not continue to make employer contributions after the ESOP has been set up. In an ESOP, cash or shares are allocated based on employees’ salary and/or tenure with the company. Thus, for most ESOPs, there is no cost to the employee. Typically, benefits paid from the ESOP to the participant will be taxed at ordinary income tax rates when those shares are bought back at retirement, death, or separation from the company (although in some cases special “net unrealized appreciation” tax treatment may be available).
Another significant difference relates to how the funds are invested. In an ESOP, plan assets must be primarily invested in company shares, whereas in a 401(k) plan, participants can usually self-direct the investment of their plan account across various asset classes. To offset this concentration of investment in company stock, employees who are age 55 or older with 10 years of participation in the ESOP can diversify into different asset classes up to 25% of their company stock account each year over a five-year period, which increases to 50% during the sixth and final year of the special ESOP diversification window period.
Finally, another difference between an ESOP and a 401(k) is that enrollment in an ESOP is automatic for all qualifying employees, whereas with a 401(k) plan, automatic enrollment is not a given and an employee must opt-in if automatic enrollment is not part of the plan. So enrolling in a 401(k) can require some effort on the part of the employee.
An ESOP is created when the shares of a company are sold (or contributed) to an ESOP trustee via a negotiated process that considers not only the agreed upon fair market value of the company, but other relevant deal terms such as financing, management incentive plans, board composition, ESOP benefit levels, and indemnity agreements.
In many cases, an advisor is hired to represent the seller(s) to manage the sales process from start to finish and to facilitate a successful sale. The advisor will first undertake an initial study that includes a modeling assignment to evaluate whether an ESOP is feasible. Once feasibility is determined and the decision is made to move forward, the advisor can assist with facilitating a capital raise for the transaction, entity restructuring, plan design, and the negotiation with the trustee team and sources of capital.