What is an ESOP?
Whether you’re a business owner or an employee considering new opportunities, you may have come across Employee Stock Ownership Plans, or ESOPs, at one point or another. An ESOP is a qualified benefit plan in which the business owners have sold some or all of their shares to an ESOP trust. This trust owns the shares on behalf of the employees, providing beneficial ownership of the company to qualified employees of the company.
ESOPs are gaining popularity among businesses of every size and industry, and for good reason. There are approximately 6,800 employee-owned companies in the United States, covering over 14 million individuals, with about 250+ new ESOPs being formed each year. With Baby Boomers retiring, we’re in a wave of business transitions, with many business owners choosing to sell their business to an ESOP rather than to a strategic buyer or private equity. Here’s a breakdown of how ESOPs work, the benefits they bring, how they stack up against more traditional qualified retirement plans such as a 401(k), and how you know if an ESOP is a good fit for your company.
How ESOPs work
As an ownership structure, an ESOP is created when an ESOP trust is formed, yearly contributions are made to it, and shares of stock are allocated among employees over time.
ESOP companies are not subjected to income tax on the federal level, resulting in significant tax benefits for the company. Employers’ contributions to the plan are also tax deductible, and employees do not pay tax on their shares until they start receiving distributions, often when they leave the company or they retire.
When employees leave the company and they are vested in their shares (vesting is based on the number of years of service required by the employer), the employee sells back its stock to the company at its fair market value. Company stock is valued annually through a formal valuation.
Depending on the company’s policy and the amount required to purchase the stock back from the employee, their distribution may be paid in a lump sum or over a period of time.
The benefits of ESOPs
There are many reasons becoming ESOPs are a good choice for companies ready to transition ownership. Some of the top benefits of ESOPs include:
- Increased employee loyalty and productivity. When employees have a stake in the company’s performance and profits, they are typically more motivated to do what’s best for the company. In general, ESOPs are attractive to employees, which also helps companies retain and recruit top talent.
- Succession planning for business owners seeking sustainability. Selling a company to an ESOP is an increasingly popular solution among business owners engaging in succession planning. This is because it comes with financial advantages, such as potential deferred or reduced capital gains taxes and income taxes in many cases. Selling to an ESOP may also enable the company to go through less turmoil during the transition and retain all its employees, compared to mergers and acquisitions.
- Tax benefits. The benefit of employers’ contributions to the plan being tax-deductible and employees’ earnings from the plan being tax-deferrable are one of the main reasons ESOPs are rising in popularity.
ESOP vs 401(k)
While ESOPs and 401(k) plans are both forms of qualified retirement plans, they have one big differentiator: who pays towards the employee’s retirement fund.
In most ESOPs, the employer buys and distributes shares among employees, often at no cost to the employee. In 401(k) plans, employees invest their own money and their employer often matches a portion of their contribution. Therefore, participants in an ESOP (all eligible employees) do not need to invest their own money to receive the benefit while participants in a 401(k) do.
How do you know if an ESOP is a good fit for your company?
The size of your company may be a determining factor in deciding if becoming an ESOP is right for you. The size and annual revenue of your company must justify the cost of the transition.
- Size: The company should have a minimum of 25 employees.
- EBITDA: Annual EBITDA (earnings before interest, taxes, depreciation and amortization) should be in excess of $1 million.
- Transition fees: Total fees for setting up an ESOP can range anywhere between $100,000 and above, including the cost of valuation, legal expenses, CPAs and other costs.
- Feasibility study: To determine if your company can and should become an ESOP, a feasibility study may be warranted.
ESOPs are also particularly popular among industries such as manufacturing, engineering and architecture. Because companies in these industries rely on the specialized training and expertise of their employees, giving employees ownership in the company helps drive interest in the business’s success and strengthens retention. Especially for business in small communities, it’s also a strategy founders may use to ensure employees are taken care of and their legacy remains intact even after they leave the company.