The Truth about Employee Ownership and Employee Stock Ownership Plans (ESOP)

January 18, 2021

You’ve probably heard of Employee Stock Ownership Plans (ESOP) but are unsure of the finer details. The goal of the following information is to educate and equip businesses owners with enough information to determine if in fact an ESOP is a good fit for their company and culture and to ultimately pursue an ESOP and employee ownership. Such plans have many benefits, and you might be missing out if you don’t give them a second glance.

To help you determine if an ESOP is the right choice for your company and culture, we’ve outlined the basics below.

How Does an ESOP Work?

ESOP stands for Employee Stock Ownership Plan. According to the National Center for Employee Ownership (NCEO), “An ESOP is a type of retirement plan, similar to a 401(k) plan, that invests primarily in company stock and holds its assets in a trust for employees.”

Companies that consider themselves employee-owned will have an ESOP. These plans are most popular within a variety of industries, family-owned businesses and profitable organizations. Think engineering firms, architects, retail, manufacturers, professional service firms, dealerships, contractors, etc. ESOPs exist across multiple industries and come in all shapes and sizes.

The NCEO reports there are around 6,500 companies in the U.S. with ESOPs, with significant representation from industries like manufacturing, professional services, finance and real estate.

ESOPs are recognized by the IRS as qualified retirement plans. Participants have an account balance that rises and falls with the appreciation of investments, as in a 401(k). With this plan, employees’ investment is in the company they work for. And where 401(k) plans usually involve employees’ own money deferred as a percentage of their income, ESOPs typically involve the employer’s money, with the employee receiving beneficiary shares of stock in the company.

Understanding ESOPs

Common misconceptions around ESOPs often keep companies from taking the leap. For owners, the idea that they’ll lose control of their business is prominent. But selling to an ESOP is different from selling to a private equity firm or strategic competitor.
With these employee ownership plans, participants are beneficiaries of the stock, and the ownership and management team typically continue to run the business as before. They don’t have to make financial information available to beneficiaries and a board-appointed trustee governs the plan.

For employees, ESOPs may seem like they have a “catch” and are too risky. However, since these plans typically don’t involve employee money, there’s a low risk for employees. Plus, the company can still choose to offer a 401(k) or other retirement plan alongside the ESOP.

Owners may also believe ESOPs are an all-or-nothing deal. But the truth is there are many minority-owned ESOPs and ownership can range from very small percentages such as 10-20% up to 100%.
One final (major) misconception is that ESOPs are too expensive and complex. However, when such an option comes across an owner’s desk, it’s often because they’re at a transition point with many potential choices ahead of them—each with its own costs and complexity. An ESOP may not be as expensive or complicated by comparison, or it may have greater benefits for your company, so it’s worth understanding the option.
If you’re already considering selling the company, don’t discount an ESOP just yet. Here are some benefits of an ESOP and how they might actually enhance your business.

Is an ESOP a good fit for your organization? Watch our recent webinar to find out more.

ESOP Benefits

For good ESOP candidates, there are many benefits to these plans. For instance, when you sell to an ESOP, you maintain and enhance your company culture. Instead of selling to a third party, you keep your workforce and give them an investment in your company. You’re rewarding them and leaving a legacy. Often, this leads to higher retention rates. And that investment opportunity is appealing to new hires, so it can bolster your recruiting efforts.

When it comes to cultivating an ownership culture with an ESOP, NCEO says, “companies that have high-involvement, idea-generating cultures generate an incremental 6-11% added growth per year over their prior performance.”

Another great benefit to ESOPs is that they come with unique tax advantages. There is favorable tax treatment for employee-owned companies that are 100% S corporation owned by the ESOP. These businesses are exempt from federal income taxation and most state income taxation, and that tax doesn’t get distributed to employees. Participants will only be taxed on appreciation when they withdraw. This tax-free ESOP structure increases companies’ cash flow.

An ESOP is also a lower-stress ownership transfer method for business succession strategies. Management can stay in place if so desired, and this method may mitigate issues relating to fractured ownership structures.

Finally, ESOPs improve liquidity and flexibility in your business. They create a market to sell shares, and they present a unique opportunity to sell to a tax-exempt stock buyer. Owners can sell all or part of their shares, pay capital gains now on shares sold and reinvest. They can also spread the sale of shares over a period of years at capital gains rates.

ESOPs: An Example
Assume an ESOP owns 20 percent of an S corporation, and the S corporation has current year taxable income of $1 million. While the $800,000 allocated to non-ESOP shareholders will be subject to income tax, the ESOP’s share of $200,000 is exempt from current tax and also most state taxes.

Is an ESOP Worth It?

Not every company is a good candidate for an ESOP. Here are a few boxes to check as you explore this route:

  • Be a profitable company.
  • Have a second level of management to continue running the company.
  • Be comfortable with employees as beneficiary owners.
  • Be large enough that the cost benefit is there year over year.

Further, if you have more suitable options on the table, such as a buyer who will pay a premium, that may be the better option depending on your objectives.

Resources to help you make sense of ESOPs

At Eide Bailly, we provide services before, during and after ESOP formation. We have all the services you need to pursue an ESOP at your business under one roof: ESOP consulting, tax, audit, legal resources, and estate and succession planning.

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