What is an ESOP?
An ESOP, or Employee Stock Ownership Plan, is a qualified retirement plan for the benefit of company employees. Whereas other qualified retirement plans invest in mutual funds or ETFs, an ESOP primarily owns stock in the employer company.
How do ESOPs work?
When a company establishes an ESOP for their employees, they must create an ESOP Trust for the purpose of owning company stock and allocating it to employees.
The company makes cash contributions or pays dividends to the ESOP. The ESOP typically uses the cash it receives to purchase company stock. In some cases, an ESOP may choose to use debt to purchase the stock. In this case, the ESOP uses the company’s contributions to pay down a note for company stock it already purchased.
The ESOP Trust allocates company stock in a fashion similar to a Qualified Profit Sharing Plan. Upon retirement, a retiree’s ESOP account is converted to cash within the ESOP and is available for retirement, just like other Qualified Retirement Plans (such as a 401(k)). At retirement, employees can roll their ESOP account to an IRA on a tax-free basis. Employees receive an annual statement that shows the value of the stock in their personal ESOP account.
Benefits of ESOPs
For owners of closely-held businesses, an ESOP provides a buyer for their stock. An ESOP may provide tax advantages to business owners looking for an exit strategy. In the case of S-Corp ESOPs, there is a major tax advantage. S-Corp ESOPs do not pay any income tax on the income attributable to the ESOP. A 100% ESOP-owned S-Corp pays no income tax. Additionally, an ESOP company can make acquisitions with pre-tax dollars.
An ESOP rewards employees with company stock and gives employees a chance to benefit directly from their company’s growth. As contributions are made to the ESOP, employees receive allocations of stock. There is no tax to the participants when company stock is allocated to their account. This allows the ESOP to purchase the company on a highly tax-favored, pre-tax basis.
Finally, ESOPs help closely-held businesses with a unique culture maintain and preserve its culture.
Who should consider an ESOP?
ESOPs are a great fit for business owners looking to sell their business. In some instances, a business owner may choose to transfer a portion of their business to family members or company executives and sell the balance to an ESOP.
Professional firms (engineering, architectural, accounting, etc) with multiple owners, who would like to have a ready market for their stock should also consider an ESOP.
Business owners or professional firms looking to “share the wealth” by rewarding employees with ownership should consider an ESOP as well.
The role of an ESOP trustee
An ESOP Trustee is the fiduciary of an ESOP Trust. The Trustee negotiates with the seller regarding purchase price and terms of the sale. The Trustee also hires and oversees all of the partners needed to establish and maintain the ESOP.
The Trustee hires a Financial Advisor to provide an initial valuation which forms the basis for the purchase price of the stock. This valuation is then updated annually for the Trustee’s review.
The Trustee also hires legal counsel to handle the legal affairs of the ESOP and a Third Party Administrator (TPA) to perform allocations, and keep the books and records for the Trust. The Trustee reviews the work of each of these partners.
An ESOP Trustee typically does not serve on the company’s Board of Directors, but they may have the right to appoint one or more board members and may function as an “ad-hoc” board member.
Our Team Can Help
When you are ready to learn more about how an ESOP can work in your situation, reach out to our team. We would love the opportunity to learn more about your needs and provide a feasibility study.