The National Center for Employee Ownership currently estimates that there are about 7,000 Employee Stock Ownership Plans (ESOPs) covering about 13.5 million employees in the United States. Roughly two-thirds of companies offer ESOPs to provide a market for a departing owner’s interest in a closely held business. Others may serve as a supplemental employee benefit plan or a mechanism to borrow money under favorable tax rules.
ESOPs are popular among manufacturers and distributors, because their employees — including plant managers, salespeople, machinists, assemblers, dispatchers, drivers and quality control workers — can directly affect profits and productivity.
How do ESOPs work?
An ESOP is a type of retirement plan that invests primarily in the company’s own stock. The employer makes tax-deductible contributions to the ESOP, which the plan uses to acquire stock from the company or its owners. Essentially, an ESOP provides a “buyer” for the company’s shares.
At the same time, an ESOP provides a powerful incentive for employees to share in the company’s growth on a tax-deferred basis. When employees retire or otherwise qualify for distributions from the plan, they can receive stock or cash.
What administrative guidelines apply to ESOPs?
Like other qualified plans, ESOPs are strictly regulated. They must cover all full-time employees who meet certain age and service requirements, and they’re subject to annual contribution limits (generally 25% of covered compensation), among other conditions.
ESOPs are subject to rules that don’t apply to other types of qualified retirement plans. For example, an ESOP must obtain an independent appraisal of the company’s stock when the plan is established and at least annually thereafter. Also, participants who receive distributions in stock must be given the right to sell their shares back to the company for fair market value. This requirement creates a substantial repurchase liability that the company must prepare for.
What financial benefits can ESOPs provide?
An ESOP provides several tax benefits. If it acquires at least 30% of a company, its owners can defer the gain on the sale of their shares indefinitely by reinvesting the proceeds in qualified replacement property within one year after the sale. Qualified replacement property includes most securities issued by domestic operating companies.
ESOPs also permit a company to finance a buyout with borrowed funds. A “leveraged” ESOP essentially permits the company to deduct the interest and the principal on loans used to make ESOP contributions — a tax benefit that can do wonders for cash flow. The company can also deduct certain dividends paid on ESOP shares. Interest and dividend payments don’t count against contribution limits.
Another advantage of ESOPs over other exit strategies is that they allow owners to cash out without giving up control over the business. Even if owners transfer a controlling interest to an ESOP, most day-to-day decisions will be made by the ESOP’s trustee, who can be a company officer. However, ESOP participants may have the right to vote on major decisions, such as a merger or sale of substantially all of the company’s assets.
Who can answer questions about ESOPs?
ESOPs offer numerous financial upsides. But there are some significant differences in the rules for administering ESOPs, depending on whether the company is set up as a C corporation or an S corporation. Consult with your tax, legal and benefits advisors to decide whether an ESOP is a viable option for you and your employees.