The number of Employee Stock Ownership Plans (ESOPs) has expanded greatly since they were formally established as qualified retirement plans in the U.S. in 1974. Today, there are approximately 7,000 active plans, with 13.5 million participants. ESOPs are found in publicly traded and closely held companies of every size, across every industry of the economy
WHAT IS AN ESOP?
An employee stock ownership plan allows employees to become beneficial owners of the stock in their company. ESOPs are defined contribution plans that primarily invest in employer stock, and are governed by the Employee Retirement Income Security Act (ERISA) of 1974. ESOPs are trusts that acquire/hold/sell the company’s stock for the benefit of participants in the ESOP, the employees.
AN EXIT STRATEGY
Today, many private business owners use ESOPs as their exit strategy. ESOPs are an excellent tool for succession planning, both for liquidity and transition. In addition to various tax benefits, ESOPs also allow business owners to reward their employees and managers with a stake in the business. The flexibility of ESOP transactions allow owners to withdraw slowly over time or all at once, depending upon their needs. In addition, the ESOP transaction process offers superior confidentiality relative to third-party sales.
THE PROS
Members of management retain their positions, allowing for a smooth transition when forming an ESOP. In addition, long-term supplier, distributor, and customer relationships remain uninterrupted.
Being part of an ESOP company can provide unique rewards for employees. Participants in the plan can receive significant retirement benefits at no monetary cost to them. Research shows ESOP companies are more productive, faster growing, more profitable and have lower turnover. In addition, an ESOP is a great way to enhance the company’s ability to recruit and retain top talent.
The tax advantages associated with ESOPs can be significant for the selling shareholders AND for the company. For the selling shareholders, the primary tax benefit can only be realized if the ESOP is purchasing shares from a C corporation.
The greater tax advantage is to the company. For all companies, payments made to the ESOP are tax deductible. Furthermore, because the ESOP is a tax exempt trust, if the ESOP holds shares in an S corporation, the earnings attributable to the ESOP owned shares are not taxable. The tax advantages and associated enhancement of cash flow of an ESOP owned company are compelling.
THE CONS
While the advantages of ESOPs are numerous, it is important to understand that an ESOP is not a good fit for every company or situation. Good candidates for an ESOP have strong management teams and generally produce consistent and predictable financial results. When utilizing an ESOP as an exit strategy, the price that an ESOP can offer per share is limited to the fair market value of those shares. Once an ESOP is established, proper administration of the plan includes third party administration, valuation, trustee, and related legal costs.
CONCLUSION
The benefits of an ESOP can be significant for selling shareholders, the management team, and the employees. With an ongoing focus on educating participants and guidance from seasoned professionals, the benefits of an ESOP normally far outweigh its complexities.
