Establishing an Employee Stock Ownership Plan (ESOP) can help gain financial liquidity, expand employee involvement, and plan for your business' future.
As a business owner, you’re focused on day-to-day operations, but future challenges are never far from your mind: How can you ensure the continued success of your business when you’re ready to retire—even if that’s 5-10 years away? Are there tax saving strategies that can be implemented when thinking about succession planning? What’s the secret to building and sustaining a strong management team to help guide the company? How can you deepen employee engagement? Read on to see how an employee stock ownership plan (ESOP) is a solution that can check all of these boxes.
When exploring the option of an ESOP for your business, it's important to learn about the ins and outs as well as how it can be an effective tool for creating a succession plan, generating tax benefits and providing employees with the incentive to coalesce into a strong management team.
Originally created in 1974, there are currently approximately 6,600 ESOPs covering more than 14 million employees. Studies show that employee-owned companies are more successful, more sustainable and have fewer layoffs than their non-employee owned peers. According to the National Center for Employee Ownership, ESOP companies grow 2% to 3% faster than would have been expected without an ESOP, with lower turnover and 2.5% higher productivity.
According to research by the Rutgers Institute for the Study of Employee Ownership and Profit Sharing funded by the Employee Ownership Foundation, employees at ESOP-owned companies experienced layoffs six times less often than those without employee ownership, with turnover rates as much as three times lower than in traditional companies. They also have more retirement savings, more engagement and involvement in the business, and more profit sharing.
What is an ESOP?
An ESOP is a qualified defined employee benefit plan, similar to a profit-sharing or 401(k) plan, that invests primarily in employer company stock. The company creates a trust to purchase shares of its stock from the selling shareholders. The shares are allocated to eligible employees' accounts over time. Participating employees have the ability to monetize their shares after they reach a certain age, leave the company or retire, subject to vesting requirements.
The transfer of ownership can be financed in two different ways. In either case, the company contributions to the trust are tax-deductible, within certain limits:
- Non-leveraged ESOP: the company contributes new shares of its own stock or cash to buy existing shares
- Leveraged ESOP: the ESOP borrows money to buy the company’s shares
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ESOPs: Myth vs. Reality
If you are at all familiar with ESOPs, it’s possible you’ve heard some misinformation about them. For example, some business owners believe they must sell 100% of the company to the ESOP. In fact, an ESOP is one of the few avenues an owner can take to sell a minority interest in their company. And while there is no minimum, you’ll want to sell at least 30% of the business to the ESOP in order to take advantage of available tax benefits.
Another misconception is that they are so complicated and expensive as to only be suitable for large businesses. While it’s true an ESOP is more expensive than setting up a 401(k) plan, it’s cheaper than most other ways of selling a business and no more complicated than selling to a third party. As for size, 97% of ESOP- owned company have less than 1,200 employees.
Benefits of Transitioning to an ESOP:
- Preserve your legacy and stay involved. After all the blood, sweat and tears you’ve invested in building your business, you no doubt hope that it will continue to thrive—in a form you’d recognize—long after you’ve handed over the reins. Like many successful business owners, much of your identity and self-worth are tied up in the business you’ve built. Selling to an outside third-party puts your legacy and the culture of your business at risk.
Maybe you’re not ready to exit the business but would like to monetize part of your investment in it. Although you might want to sell to an insider, it’s rare for family members or employees to have access to the financial wherewithal necessary to buy you out. An ESOP solves that problem and enables you to continue to run the company, while helping all parties save on taxes.
- Take advantage of tax benefits. As a qualified benefit plan, an ESOP provides many tax advantages. Congress created specific tax incentives to promote increased use of ESOPs in order to broaden the ownership of capital with most states following suit. Here is a high-level look at these benefits.
In C-Corporation transactions, shareholders selling at least 30% of their stock to an ESOP have the ability to defer capital gains tax indefinitely subject to meeting certain statutory requirements.
Beginning in 1998, ESOPs were allowed to own stock in S-Corporations. If an ESOP owns 100% of the common stock, the company can elect an S-Corporation tax status to eliminate all federal income tax as well as state income tax in most states. This increased cash flow allows for faster debt repayment.
- Recruit and retain a strong management team, increase employee engagement and improve company performance. Study after study has shown that employees who have a stake in their company tend to be more committed and engaged. With a greater degree of cooperation between management and employees, productivity and performance are known to rise. A 2010 study conducted by Phil Swagel of the McDonough School of Business at Georgetown University tracked the performance of ESOP-owned companies and showed that even during the first year of the 2008 recession, they were adding employees and enjoying double-digit growth.
In another study of ESOP performance conducted by Dr. Joseph R. Blasi and Dr. Douglas L. Kruse, professors at the School of Management and Labor Relations at Rutgers University, 1,100 ESOP companies were compared to 1,100 non-ESOP companies. The companies were followed for over a decade and the results showed that ESOP- owned companies had a business survival rate of 77.9% compared to 62.3% for non-ESOP companies.
Making the transition to an ESOP doesn’t happen overnight. Like any worthwhile business endeavor, it takes preparation, planning, and patience; however, the rewards for both you and your employees can be significant.