Weighing the Risks and Benefits of ESOP

True to its name, an employee stock ownership plan (ESOP) is a type of employee benefit plan, similar in some ways to a profit-sharing setup. The National Center for Employee Ownership (NCEO) estimates that approximately 14 million workers currently participate in an ESOP, making it the most common form of employee ownership in the U.S.

While some public companies participate, their ability to offer stock options make them significantly less likely to offer these plans (case in point, fewer than 10% of plans are in public companies). Most employees who take advantage of ESOPs are employed by small, closely held companies.

While there are some risks involved, particularly for S-corporation companies, ESOPs can offer the highest level of retirement benefits, compared to other employee benefit plans.

How does an ESOP work?

Most often, a company that wants to offer an ESOP sets up a trust fund, into which it contributes new shares of its stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares. In that case, the company would make cash contributions to the plan to enable it to repay the loan. Shares in the trust are allocated to individual (full-time) employee accounts. Depending on whether vesting is all at once or gradual, those shares must be 100% vested within three to six years. When employees leave the company, the company buys back their stock at its fair market value (provided there is no public market for the shares).

What are the Benefits of an ESOP?

In almost every case, ESOPs are a contribution to the employee, not an employee purchase. They are commonly used for three primary objectives.

  1. As part of succession/exit planning
  2. To motivate and reward employees with a supplemental employee benefit plan
  3. To take advantage of incentives to borrow money in a tax-favored manner

ESOP for Succession / Exit Planning

About two-thirds of ESOPs are used to create a ready market for the shares of a departing owner of a profitable, closely held company.[1] A company can make tax-deductible cash contributions to the ESOP to buy out an owner's shares, or enable the ESOP to borrow money to buy the shares.

ESOP for Supplemental Employee Benefits

Retaining and motivating key employees can be a challenge, particularly if the organization lacks the resources to offer competitive compensation. An ESOP can answer challenges both around liquidity crunch and talent retention, while also aligning employee goals and ambitions with that of the company.

ESOP for Tax Incentives

ESOPs are unique among benefit plans in their ability to borrow money. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.

  • Because contributions of stock are tax-deductible, companies can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP.
  • Because cash contributions are tax-deductible, a company can contribute money on a discretionary basis year-to-year and take a tax deduction for it – whether the contribution is used to buy shares from current owners or to build up a cash reserve in the ESOP.
  • Because contributions used to repay a loan the ESOP takes out to buy company shares are tax-deductible, the ESOP can borrow money to buy existing shares, new shares, or treasury shares.
  • Because (reasonable) dividends are tax-deductible, reasonable dividends used to repay an ESOP loan, passed through to employees, or reinvested by employees in company stock are tax-deductible.

Companies aren’t the only ones to benefit from tax controls. Employees only pay tax on the distribution of their accounts. They can roll over their distributions in an IRA or other retirement plan or pay current tax on the distribution, with any profits taxed as capital gains.

What are the risks and caveats of ESOP?

Probably the most notable risk or challenge of an ESOP is the cost and complexity of set up. To offer an ESOP, a company should have at least 30 employees and sustainable annual pre-tax profits of $500,000+. They must create a market for shares, be sufficiently capitalized, and have the ability to support the complexity of the plan and its annual plan contributions.

While these guidelines may not be prohibitive, it’s important to be aware of these and a few other restrictions:

  • Under current law, ESOPs cannot be used in partnerships and most professional corporations
  • ESOPs in S corporations do not qualify for rollover treatment and have lower contribution limits
  • Private companies must repurchase shares of departing employees (which can turn into a major expense, particularly as large numbers of baby boomers depart the workforce at once)
  • Whenever new shares are issued, the process dilutes the stock of existing owners – that dilution must be weighed against the tax and motivation benefits for the ESOP
  • ESOPs will improve corporate performance only if combined with opportunities for employees to participate in decisions affecting their work

Despite any risks, ESOPs offer a viable way for companies to strengthen their workforce by supporting their employees' retirement goals and savings. Giving employees a greater sense of belonging encourages retention and elevates their desire to help the company meet its goals. 

Because the benefits vary based on corporate structure, it’s important to connect your employees’ needs, your organizational structure, and your corporate end goals before engaging an ESOP. For more information about how you can engage the benefit or recommend it to your clients, see How an ESOP Improves Employee Retention and the Bottom Line.

And more information about how to set up and use an ESOP can be found on the National Center for Employee Ownership site.

 Join the conversation and receive updates of new posts:

Subscribe to the Banking Blog

[1] http://www.dailybusinessreview.com/id=1202795437970/The-Path-to-a-Successful-Exit-From-Your-Business?slreturn=20170806180358

Topics: ESOP

Leave A Comment

Related Posts