Is an ESOP the Right Choice for Your Company?

Summary:

• Structure and Purpose: An ESOP is a qualified defined contribution retirement plan that allows employees to gain partial or full ownership of a C or S corporation, often serving as a tool for business succession and a motivator for talent retention.
• Mechanics and Participation: Companies fund these plans by contributing shares or borrowing money to purchase them through a trust; eligibility typically begins after one year of service, with shares allocated based on a uniform percentage of compensation.
• Financial and Tax Advantages: Businesses can leverage significant tax deductions on contributions and loan interest, while owners of closely held C corporations may defer capital gains taxes by selling at least 30% of their stock to the plan.

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Employee stock ownership plans (ESOPs) have been in the headlines recently, but they’ve been around for decades. The difficulties associated with attracting and retaining talent, the influx of private equity into professional services and other businesses, and business succession issues are among the reasons for renewed interest in ESOPs. Employees and prospective employees often find it attractive to have a financial stake in the company’s success, which can also drive working motivation. Below are answers to common questions about ESOPs to help you determine whether this structure is the right choice for your business. 

What Is an Employee Stock Ownership Plan? 

ESOPs are qualified defined contribution plans in the form of stock bonus plans or stock purchase/money purchase plans. They’re governed by Internal Revenue Code Section 401(a) and the Employee Retirement Income Security Act (ERISA). Under an ESOP, employee participants take part ownership of the business through a retirement savings arrangement. Meanwhile, the business and its existing owners can benefit from some tax breaks, an extra-motivated workforce, and a clearer path to a smooth succession. 

How Does an ESOP Work? 

To implement an ESOP, you establish a trust fund and either: 

• Contribute shares of stock or money to buy the stock (an “unleveraged” ESOP), or 

• Borrow funds to initially buy the stock, and then contribute cash to the plan to enable it to repay the loan (a “leveraged” ESOP). 

The shares in the trust are allocated to individual employees’ accounts, often using a formula based on their respective compensation. The business must formally adopt the plan and submit plan documents to the IRS, along with certain forms. 

Can All Companies Offer an ESOP? 

No. The company must be structured as a C corporation or an S corporation, and the shareholders must agree to sell their shares. 

How Big Does My Company Have to Be to Offer an ESOP? 

Surprisingly, size is not the main consideration; profitability is. In addition, companies have to be willing to enter a long-term financial commitment. 

How Are ESOPs Funded? 

ESOPs are funded with company stock that is held in a trust fund set up by the company. The shares in the trust fund can come from existing company shares, newly issued shares, or shares purchased with borrowed money. Typically, the ESOP trust buys a percentage of the business’s shares; the payout goes to the shareholders, and the company takes out a loan to repay the ESOP. 

How Is the Trust Fund Managed? 

The trust fund is managed by a designated trustee who acts as the plan’s fiduciary. A fiduciary is legally and ethically responsible for managing the trust for the benefit of the ESOP trust’s owners. As part of this duty, the fiduciary is responsible for maintaining that all participants have voting rights and are subject to the same rules. 

Who Can Participate in an ESOP? 

Plans differ, but generally, employees who are 21 or older and have completed one full year of service (usually defined as 1,000 hours of completed service) can participate. 

How Are Shares Earned? 

In a contributory ESOP, management sets a percentage of pay compensation, which must be the same for all eligible participants. If, for example, the percentage is 8% of salary, everyone from the CEO to the cleaning crew receives a share equivalent to 8% of their compensation. The dollar amounts vary by employee, but the percentage does not. It’s important to note that there are annual contribution limits, and special rules apply for disqualified or highly compensated employees. 

Are All ESOPs Structured the Same Way?  

No. An ESOP generally owns between 50% and 100% of the company’s shares. If the ESOP owns 100%, the company is fully owned by its employees. If the ESOP owns less than 50%, the ESOP is a minority shareholder, and control of the company effectively remains with the original shareholders or owners. 

How Does Vesting Work? 

Distributions from the plan are generally tied to a process called vesting. An employee may be vested immediately, after a certain amount of time (e.g., five years), or gradually over time (e.g., 20% after year one, 40% after year two, 60% after year three, 80% after year four, and 100% after year five). When a vested employee leaves, the company buys back their shares and gives the employee the shares’ cash value.  

But there’s a caveat: Being vested doesn’t necessarily mean the ESOP shareholder can cash out. To cash out, the employee needs to have experienced a life event, such as retirement, termination, disability, or death. Age is an additional factor. For example, if the person is below age 59 1/2, making a withdrawal may subject them to a 10% penalty. 

What Are the Tax Benefits of an ESOP?  

The taxation of ESOPs can be complicated. However, employers can generally deduct contributions to the ESOP and defer taxes on their ESOP benefits until they receive their vested amount. 

Among the biggest benefits of an ESOP is that employer contributions to qualified retirement plans (including ESOPs) are typically tax-deductible. However, employer contributions to all defined contribution plans, including ESOPs, are generally limited to 25% of covered payroll. But C corporations with leveraged ESOPs can deduct contributions used to pay interest on the loans (meaning the interest isn’t counted toward the 25% limit). 

Dividends paid on ESOP stock passed through to employees or used to repay an ESOP loan may be tax-deductible for C corporations, so long as they’re reasonable. Dividends voluntarily reinvested by employees in company stock in the ESOP are also usually deductible by the business. Employees, however, should review the tax implications of dividends. 

Shareholders in some closely held C corporations can sell stock to the ESOP and defer federal income taxes on any gains from the sales, with several stipulations:  

1. The ESOP must own at least 30% of the company’s stock immediately after the sale.  

1. The sellers must reinvest the proceeds (or an equivalent amount) in qualified replacement property securities of domestic operating corporations within a set period. 

Finally, when a business owner is ready to retire or otherwise depart the company, the business can make tax-deductible contributions to the ESOP to buy out the departing owner’s shares or have the ESOP borrow money to buy the shares. 

Considerations Before Forming an ESOP 

Transparency is a key ingredient to making an ESOP successful. When considering forming an ESOP, business leaders must keep everyone apprised of important company matters. Employees who feel invested both financially and informationally may feel more commitment to, engagement with, and loyalty to the company. If you’d like to learn more about ESOPs and whether this structure could benefit your business, use the form below to contact us today.