Planning for the Future? Here's How an ESOP Could Help You and Your Company
Learn how ESOPs can be effective tools for creating succession plans, generating tax benefits and providing employees with the incentive to coalesce into a strong management team.
As a business owner, you’re focused on day-to-day operations, but future challenges are never far from your mind: How can you ensure the continued success of your business when you’re ready to retire — even if that’s 5 to 10 years away? Is there a way to achieve tax savings when diversifying your investment to pursue other business opportunities? What’s the secret to building and sustaining a strong management team to help guide the company? How can you deepen employee engagement? An employee stock ownership plan (ESOP) is a viable solution.
When exploring the option of an ESOP for your business, it's important to learn about the ins and outs as well as how it can be an effective tool for creating a succession plan, generating tax benefits and providing employees with the incentive to coalesce into a strong management team.
Originally created in 1974, ESOPs are now installed in more than 7,000 companies and cover 13.5 million employees. Studies show that employee-owned companies are more successful, more sustainable and have fewer layoffs. ESOPs outperformed the S&P 500 for the decade 2002 to 2012, according to a study prepared by Ernst & Young’s Quantitative Economics and Statistics Practice (QUEST) for Employee-Owned S Corporations of America. Research from The ESOP Association also supports this trend. During the 2008–2011 recession, the average layoff rate for non-ESOP companies was close to 12 percent, while it was just 3 percent for ESOP companies, according to The ESOP Association's research.
What is an ESOP?
An ESOP is a qualified defined employee benefit plan, similar to a profit-sharing or 401(k) plan, that invests primarily in employer company stock. The company creates a trust to purchase shares of its stock from the selling shareholders. The shares are allocated to eligible employees' accounts over time. Participating employees have the ability to monetize their shares after they reach a certain age, leave the company or retire, subject to vesting requirements.
The transfer of ownership can be financed in two different ways. In either case, the company contributions to the trust are tax-deductible, within certain limits.
- Non-leveraged ESOP: the company contributes new shares of its own stock or cash to buy existing shares
- Leveraged ESOP: the ESOP borrows money to buy the company’s shares
ESOPs: Myth vs. Reality
If you are at all familiar with ESOPs, it’s possible you’ve heard some misinformation about them. For example, some business owners believe they must sell 100 percent of the company to the ESOP. In fact, an ESOP is one of the few options to transfer partial ownership. If you do, you’ll probably want to transfer at least 30 percent of the business to employees in order to take advantage of available tax benefits. Another misconception is that they are so complicated and expensive as to only be suitable for large businesses. While it’s true an ESOP is more expensive than setting up a 401(k) plan, it’s cheaper than most other ways of selling a business and no more complicated than selling to a third party. As for size, according to the National Center for Employee Ownership's August 2016 edition of the Top 100 List, the 10th-largest majority-owned ESOP-owned company has 1,100 employees. The remaining 6,900 ESOPs in existence have fewer employees than that.
Three Benefits of Transitioning to an ESOP
1. Preserve your legacy and stay involved. After all the blood, sweat and tears you’ve invested in building your business, you no doubt hope that it will continue to thrive — in a form you’d recognize — long after you’re gone. Much of your identity and self-worth are tied up in the business. Selling to an outsider includes the risk of substantial change to the very heart of your enterprise.
Maybe you’re not ready to exit the business but would like to monetize part of your investment in it. Although you might want to sell to an insider, it’s rare for family members or employees to have access to the financial wherewithal necessary to buy you out. An ESOP eliminates that problem and enables you to continue to run the company’s operations, while helping all parties save on taxes.
2. Take advantage of tax benefits. As a qualified benefit plan, an ESOP provides many tax advantages. Congress created specific incentives to promote increased use of ESOPs in order to broaden the ownership of capital, and in most cases, the states have followed suit. Here is a top line look at these benefits. In C-Corporation transactions, shareholders
selling at least 30 percent of their stock to an ESOP have the ability to defer capital gains tax indefinitely as long as they meet certain statutory requirements. As of 1998, ESOPs were allowed to own stock in S-Corporations. If an ESOP owns 100 percent of the common stock, the company can elect S-Corporation tax status and avoid paying federal income tax completely, thereby increasing cash flow to repay debt more quickly.
3. Recruit and retain a strong management team, increase employee engagement and improve company performance. Study after study has shown that employees who have a stake in their company tend to be more committed and engaged. There is generally less friction between management and employees and usually a greater degree of cooperation. Consequently, productivity and performance are known to rise. A 2010 study conducted by Phil Swagel of the McDonough School of Business at Georgetown University tracked the performance of companies owned by S-Corporation ESOPs and showed that even during the first year of the recession of 2008, they were adding employees and enjoying double-digit growth.
In another study of ESOP performance conducted by Joseph R. Blasi and Douglas L. Kruse, professors at the School of Management and Labor Relations at Rutgers University, 1,100 ESOP companies were compared to 1,100 non-ESOP companies. The companies were followed for over a decade and the results showed that ESOPs had increased sales and employment between 2.3 percent and 2.4 percent. ESOP-owned companies had a business survival rate of 77.9 percent compared to 62.3 percent for non-ESOP companies.
Making the transition to an ESOP doesn’t happen overnight. Like any worthwhile business endeavor, it takes preparation, planning, and patience. The rewards for both you and your employees, however, can be significant.