There are more than 6,700 employee stock ownership plans (ESOPs) across the country, which cover 14 million participants and hold assets of more than $1.3 trillion, according to the U.S. Department of Labor’s most recently available data.
Despite these statistics, however, many family owned or privately held business owners have no direct experience with an ESOP and only a basic understanding of how one could benefit their companies. Given this limited awareness of ESOPs, we rounded up some of the most common questions about the structure, details and advantages of this business transition and employee benefit tool.
What is an ESOP?
An Employee Stock Ownership Plan, or ESOP, is a qualified defined contribution employee benefit plan authorized under the Employee Retirement Income Security Act (ERISA).
An ESOP is similar to a profit-sharing plan, but a key difference is that the ESOP invests primarily in the stock of the sponsoring employer. It can be a beneficial transition strategy to help exiting owners achieve their retirement goals and give back to loyal employees.
What kind of company is right for an ESOP?
ESOPs are used across a variety of industries and business types, but there are some overarching characteristics of companies that implement them. While there is no minimum size or annual revenue requirement to set up an ESOP, companies with approximately 20 or more employees and annual revenues of at least $10 million generally fare best with this model.
The key to ESOP success is spreading out the formation and annual administration costs over a broad employee base. Reasonably consistent profitability, the ability to leverage the business with debt and a strong management team are other important factors.
What are the tax advantages of an ESOP exit strategy?
An Employee Stock Ownership Plan can provide a ready market for the shares of an exiting owner of a privately held company. While limited by adequate consideration rules (the ESOP can pay no more than fair market value), ESOPs have tax advantages that benefit the selling shareholder and the corporation.
For instance, the owner of a C Corporation can defer capital gains taxes on the sale indefinitely provided that they elect and meet the provisions of section 1042 of the Internal Revenue Code. While S Corporations do not have this benefit, they can essentially operate income tax free if the ESOP owns 100 percent of the stock. Consult your tax advisor for guidance related to your particular tax situation.
How much stock can an ESOP own?
An ESOP may own a portion or all of the stock in a company. Partial ownership by an ESOP is a great option for family owned businesses that wish to retain family control but also want to reward and build additional incentives for an employee base considered to be part of the family.
Do the employees actually own the company?
No, the ESOP is structured as a trust, which has governance requirements. The employees are beneficiaries of that trust. A trustee administers the plan and makes the majority of shareholder decisions; however, major corporate actions have pass-through voting rights to participants.
Are there other benefits of using an ESOP?
Beyond the financial advantages an ESOP offers, there are also cultural and motivational benefits. Forming an ESOP allows the company’s ownership to reward or invest in its employees. Giving employees an ownership stake ties them directly to the company’s overall performance, which is often a motivating factor to improve their personal job performance.
Employee Stock Ownership Plans also provide stability to the other stakeholders of a company by limiting the transition disruption to customers, suppliers and the community in which the business is located.
For more information on ESOPs or to decipher if it is the right tool for your family owned or privately held business, contact me at firstname.lastname@example.org or 610.376.1595.
Contributed by Ryan P. Hurst, ASA, Manager in RKL’s Business Consulting Services Group. Ryan serves the valuation, investment banking and consulting needs of clients in a wide variety of industries. His expertise includes performing valuations for gifting, estate planning and administration, employee stock ownership plans (ESOPs), buying or selling a business, buy/sell agreements, fair value accounting and GAAP reporting, litigation support for shareholder disputes and strategic alternatives analyses.
Don’t miss the latest RKL business analysis and insights. Sign up for the monthly Working Capital e-news.
Working Capital blog disclaimer