Employee Stock Ownership Plans (ESOPs)
What are ESOPs?
An ESOP (Employee Stock Ownership Plan) is an employee benefit plan that invests primarily in employer stock.
An ESOP is a highly tax-favored way for employees to share ownership in their company through a trust fund.
Companies make tax-deductible contributions to the ESOP, and those contributions are either allocated to participant accounts or used to repay the ESOP loan.
When a portion of the loan is paid, a portion of the shares is allocated to participant accounts.
ESOPs allocate shares to each eligible employee every year, giving employees an increasing ownership stake as they accumulate seniority.
The ESOP distributes these shares to employees, usually sometime after they leave the company, so they can use them to fund their retirement.
All ESOP rules balance two competing interests: that they are flexible enough so the employers will be willing to set them up, but not so flexible that they are easy to abuse.
An ESOP company is worth what a willing buyer would pay for the company to have the right to its future earnings and current assets.
Advantages of ESOPs:
Tax-advantaged (to seller, company, and employee)
Company makes tax-deductible contributions of stock or cash to buy stock.
Stock is allocated to accounts for individual participants.
Participants receive stock or its cash value on retirement or termination of employment.
Employees vote stock through a trust.
6 Reasons to Consider an ESOP
Workers can control the future of their jobs.
The selling owners can get a fair price for their stock.
The company can write off the expense of buying the seller’s stock.
A Sub-S company’s ESOP pays no federal income tax.
The seller’s proceeds from an ESOP stock sale may be tax-free.
Sale to an ESOP can preserve the company’s independence and reward the people who made it a success.
Best Uses of ESOPs
Sale of a family owned business (See: Carris Reels, Rosauers Supermarkets, National Forge and Once Again Nut Butter)
Sale of a majority interest in a company business (See: Carris Reels, Rosauers Supermarkets, MBC Ventures, Republic Container, National Forge and One Again Nut Butter)
There payroll is a high % of operating expenses (See: Homeland Grocery, Rosauers Supermarkets and Once Again Nut Butter)
Where broad based employee ownership is desired (See: Republic Container, Carris Reels, Rosauers Supermarkets, MBC Ventures and Once Again Nut Butter)
When company and sellers have use for tax deductions (See: Carris Reels, Rosauers Supermarkets, Fulton Tool & Die, National Forge and One Again Nut Butter)
Where independent valuation is acceptable to sellers
Most Common Uses for ESOPs
Cheap capital for business investment, expansion, or divestiture (See: Homeland Grocery, Carris Reels, MBC Ventures and Once Again Nut Butter
Principal and interest tax-deductible (See: Homeland Grocery, MBC Ventures, Republic Container and Once Again Nut Butter
Deduction for dividends distributed to employees
Deduction for dividends used by ESOP for debt retirement (See: Homeland Grocery, Rosauers Supermarkets, MBC Ventures, National Forge)
Deduction for dividends reinvested by employees
Creating a local market for selling stockholders
Anchoring jobs and local business in local communities (See: Homeland Grocery, Rosauers Supermarkets, Carris Reels, MBC Ventures, Republic Container and Once Again Nut Butter
Local control over future investment and disinvestments (See: Homeland Grocery, Rosauers Supermarkets, Carris Reels, MBC Ventures, Republic Container and Once Again Nut Butter
ESOP Varieties
Complete Buyout of a C Corporation Shareholder, Followed by a Corporate S Election
Basic stock bonus (non-leveraged) diagrams and explanation
Examples of different types of leveraged esops
Leveraged ESOP in C Corp (See: Rosauers Supermarkets, Carris Reels, MBC Ventures, Republic Container)
Rollover capital gains deferral ESOP (1042) (See: Carris Reels, Fulton Tool & Die)
Sub S ESOP (See: MBC Ventures, Fulton Tool & Die)
Who Uses ESOPs?
Many different organizations, businesses, individuals use ESOPs (Employee Stock Ownership Plans) such as:
Business Owners & Employee Ownership
Employee Groups Buying Their Companies
See all our ESOP Case Studies
Various Advantages to Employee/Owners
Opportunity to share in company’s growth and build capital
Deferral and reduction of taxes
Stock can be received at no risk or expense
ESOP can save jobs
Dividend income
Advantages to C Corporation Seller
Tax deduction up to 25% of payroll to repay stock purchase loan principal +
Unlimited tax deduction for payment of reasonable interest on ESOP loan +
Dividends tax deductible – if paid in cash, used to pay stock purchase debt, reinvested by participant +
Tax on capital gains postponed indefinitely through rollover (for Subchapter “C” Company) to an ESOP or Eligible Worker Owned Cooperative.
Solution for business succession & provides market for closely held stock
Increased cash flow and working capital
Majority control can be maintained
Greater productivity and motivation from employee owners
Advantages to Majority ESOP of Sub S Election
ESOP exempt from tax on its portion of Company income
Income grows tax free in ESOP & is only taxed to participants upon distribution
ESOP may distribute benefits in cash, not stock
No dissolution of S corp. due to ESOP distribution
100% ESOP owned S corporation pays no federal income tax
How Do ESOPs Work?
Popular Types of ESOPs: Leveraged vs. Non-Leveraged
There are several types of ESOPs, but one of the most popular is a leveraged ESOP. In a “leveraged” ESOP, the ESOP borrows money and buys the owner’s stock. The Company usually guarantees the loan, and contributes enough money each year to enable the ESOP to repay the loan. In a “non-leveraged” ESOP, the ESOP uses company contributions to purchase stock each year from individual owners or from the company. The company deducts the contributions from its taxable income. The ESOP stock is allocated to employee trust accounts and when employees retire, they receive their shares or the cash value of those shares. Since ESOPs are extremely flexible, there are many variations on this arrangement.
ESOP Basics
Employee Accounts
Stock is valued annually by an independent valuation firm
Contributions & allocations are made to employee accounts, usually based on pay for people who work over 1000 hours/year
Participation – plan can have age and service eligibility rules
Vesting – can be immediate, often 6 year graduated or 3 year cliff
Distribution upon death, disability or retirement, or termination for other reasons if vested
Taxes –taxed as pension with rights to rollover to IRA
Growing your ESOP balance is based on increased value in the company, years of employment, and generally rate of pay
Contributions to the ESOP
Employees do not contribute to the ESOP
Board of directors determines contribution amount each year – discretionary, but must be regular
Except – if money borrowed through ESOP, allocations must be made to employee accounts as loan is repaid
Allocations to accounts are made as of end of plan year
Employee portion is typically based on your eligible compensation – can be flatter
Stock must be valued annually by an independent appraiser
Vesting for Employee ESOP Accounts. Below are the legal limits, but the plan can be more generous:
Year of service = 1,000 hours
Prior service may count
Graduated vesting schedule beginning at year 3 and ending in year 7 or 100% vesting after 5 years
Exceptions - Retirement, death, or disability
Plan participatns forfeit unvested balance
Distribution Start Timing
Retirement, death, or disability- No later than one year after end of final plan year
Any other reason - No later than five years after end of participant’s final plan year, unless there is an outstanding acquisition loan
Distribution Method
Most distributions are in cash
In some plans, employees can demand stock
Right to demand cash if company is not publicly traded
Single lump sum or annual installments
Over no more than 5 years
Taxes on ESOP Distributions
You can defer taxes by rolling over your ESOP distribution to an:
IRA
Other qualified retirement plan
If you take the cash before age 59 ½, there is:
20% federal withholding
10% early withdrawal penalty
If you take a stock distributions:
You are not taxed on the net unrealized appreciation while the stock was in the ESOP
A privately held company must let you sell your stock back to company – which is called a “Put Option”
How Employee ESOP Balance Can Grow
Shares added to employee account because:
Shares of company stock contributed as required by a leveraged ESOP loan
Shares contributed in exchange for ESOP purchase from an owner
Additional shares contributed by company as a stock bonus or profit sharing
Shares forfeited by partially or non-vested participants who leave employment
Shares redeemed from retirees and then re-contributed to ESOP by the company
Change of share value in employee account
Shares can increase in value with greater employee participation and continued product/ service innovation based on long-term stake.
Value can decrease due to market pressures, poor management, or catastrophe– but participatory employee ownership can turn these around.
EMPLOYEE OWNERSHIP THAT FITS YOUR NEEDS
We can smoothly transition your privately-owned business to a worker-owned one that meets the seller’s objectives, is socially responsible and includes employee participation. Learn more
TESTIMONIAL
“When we founded our ESOP I was afraid that I was asking too much because of the unique provisions I wanted. I had talked to several other potential attorneys and advisors. They said “Why, and you can’t do that”. Deb cut through ESOP law and got our ESOP exactly like I wanted and it has worked beautifully. Deb is smart, fast, knowledgeable and efficient. I would recommend her for anyone considering employee ownership.” -Bill Carris, selling owner & current board chair, Carris Reels, Inc.
