What is an ESOP?

An Employee Stock Ownership Plan, or ESOP, is a qualified benefit plan that is established when a business owner sells all or a portion of their share in the business to an ESOP Trust. Employees gain shares in the company, and selling ownership provides a buyer for the company and a strategy for succession to pass ownership on to the next group of management.

Let’s explore ESOP’s popularity, reasons to consider pursuing this option, and next steps you can take.

Are ESOPs common?

According to the National Center for Employee Ownership, there are more than 6,500 unique ESOPs in the United States, employing 10.7 million people with total assets of more than $2.1 trillion. ESOPs are popular among small- and middle-market businesses. The top five most common industries among privately held ESOP companies are Professional Services, Manufacturing, Construction/Contractors, Finance/Insurance/Real Estate and Wholesale Trade.

Why consider an ESOP?

An ESOP can be a huge advantage to building wealth for retirement:

Succession Planning

Most companies fall into one of three categories for succession planning:

• 15% will pass the company to a family member
• 20% will sell the company to private equity
• 65% have no immediate solution documented for the next stage of ownership

Management often continues to run the company after the transition to an ESOP to ensure operational and financial stability. Employees will not own shares to the company directly, but they do have a financial interest in the shares allocated to their account.

Transitioning to an ESOP can often be a vehicle to retain and incentivize the next level of management by offering stock appreciation rights (SARs) or attaching warrants – enhanced financial benefits for employees – to the ESOP.

Tax Advantages

An ESOP is available for both S-corps and C-corps with different advantages for each. An S-corp is most common, as it allows a company to be tax-exempt for federal income tax on the portion of the company that is owned by the ESOP. For example, if a company is 100% ESOP S-corp, they will be completely tax-exempt from federal income tax.

A C-corp provides the selling shareholder the ability to defer capital gains tax on the sale of the company through a 1042 exchange. While a C-corp does not have the tax-exempt status of an S-corp, certain deductions, such as ESOP contributions, can aid in reducing the company’s tax liability. Additionally, if company ownership wants to transition a C-corp to an S-corp, they can do so after a five-year reporting requirement and use both tax advantages.

Rewarding Employees

An ESOP helps protect the independence of the company along with the jobs of the employees. If ownership decides to sell to an outside interest such as private equity or a strategic buyer, often times there are organizational changes that put local jobs at risk. With an ESOP, the current management structure remains in place and the company can continue to operate free from external influence.

An ESOP raises the benefits for employees across the organization. At no cost to the employee, they receive an additional wealth-building tool for retirement. And, unlike a 401(k), employees are not required to contribute for shares of the company to be allocated to their account. Historically, ESOPs have a higher rate of return compared to a 401(k), and the funds will grow tax-free until distribution.

Marketing Advantages

Research shows that companies with employees who think and act like owners tend to be more productive, more profitable, faster growing and have higher retention than their peers. While an ESOP will not transform your company culture, it will certainly enhance an already healthy culture.

An ESOP can attract and retain talent because it is a wealth-building tool for employees and it reinforces a culture of valuing employees by sharing in the company’s success with those who contribute to it through their daily work.

Next steps

To determine if an ESOP is the right fit for your business, consider these factors:

• Size: This could be a great option for your company if you have at least 25 employees.
• Cash flow: Your company’s Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) should be in excess of $1 million annually.
• Transition fees: Your company would need to cover the cost of setting up an ESOP, which typically exceeds $100,000 and includes the cost of valuation, legal expenses, CPAs and other fees.
• Feasibility study: It might be helpful to conduct a feasibility study to determine if your company can and should become an ESOP.

Reach out to me to learn more about ESOPs.

Bankers Trust and its affiliates and their representatives do not provide tax or legal advice. You should consult with your tax and legal advisors regarding your unique situation and needs.

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