How ESOPs Work
An employee stock ownership plan (ESOP) is similar to a profit-sharing plan. It’s a qualified retirement plan and must follow the same coverage, participation and nondiscrimination provisions that govern all retirement plans. However, ESOPs are required to be primarily invested in company stock. They are not required to diversify their investments. While other retirement plans can invest in the employer’s stock, ESOPs have unique features and specific uses, making them popular as vehicles for corporate succession planning and finance.
Whether you want to use an ESOP for benefiting employees, supporting corporate growth, corporate finance or corporate succession planning, Employee Benefits Law Group has the expertise to guide you through the process.
Key Differences Compared to Other Plans
There are three types of ESOPs. These plans may borrow money from the company, a third-party lender or a related party to purchase stock from shareholders or buy new shares from the company itself. They can also sell shares to related parties or to the company. They have flexible rules for financing stock transactions, funding benefit distributions and retaining control of company stock or trading in publicly traded stock. An ESOP’s S corporation income is not subject to unrelated business income tax (UBIT).
Our Executive Short Course is a step-by-step guide of curated materials where you can read, watch, or listen to get a grasp on ESOP basics.
ESOP Advantages in Corporate Financing
To fund an ESOP’s purchase of stock from existing shareholders or subscribe to new shares of company stock (raising new working capital):
- Both the principal and interest on an ESOP loan are tax deductible.
- C corporations may pay tax-deductible dividends to fund payments on an ESOP loan.
- S corporations may make shareholder distributions to an ESOP that may be used to fund a portion of the ESOP share purchase, ESOP loans or to pay out benefits to participants.
- ESOPs can borrow from related parties.
- ESOPs can be funded with higher-deduction limits than a usual profit-sharing plan.
ESOP Advantages in Corporate Succession Planning
For succession planning, and to fund the purchase and sale of part or all of an owner’s interest in a company, an ESOP can offer excellent flexibility and deliver motivating tax advantages, including:
- The owner(s) having the option to sell to the ESOP partially, or in stages over a period of years so they can gradually ease out of the company – particularly compelling for sellers with management responsibilities, or a desire to remain involved with their company.
- In a C corporation, the selling owner(s) potentially deferring taxation on the capital gain from the sale of their shares by using the section 1042 “rollover” to reinvest their sales proceeds in stocks and bonds of U.S. companies.
- The company being able to fund the transaction entirely with pre-tax dollars.
- S corporation distributions to an ESOP ultimately paying for 30% to 60% of an ESOP transaction.
- The cost of ESOP transactions being most often much lower than a third-party acquisition of a private company.
ESOP Impacts as an Employee Benefit Plan
ESOPs do not have to be used just for complex financed transactions. They can allocate shares to employees that are simply contributed to by the company (i.e., newly issued shares). The company can deduct the contribution of the shares based on their appraised value or fair market value. Employees are not taxed on that allocation of stock. ESOPs are the only tax deductible and pre-tax method for granting shares to a broad base of employees – whether in a public or private company.
Employees are not taxed until they receive their benefits at retirement, death, disability or over time after they leave the company. Even then, most ESOP benefits are rolled over to IRAs or other retirement plans – until retirement distributions are required.
Most ESOPs are used by closely held companies with about 20 employees and up, but can be found in companies ranging from family-owned machine shops to large public companies. The approximately 7,000 ESOPs and equivalent plans in the U.S. cover over 13.5 million employees.
ESOPs help businesses keep jobs and improve performance. According to the National Center For Employee Ownership (NCEO):
- Employee-owners were four times less likely to be laid off during the recent recession.
- ESOP companies are 25% more likely to stay in business.
- Employees at ESOP companies have 2.5 times greater retirement accounts than equivalent employees elsewhere.
- Corporate performance improves 4% to 5% on average in the year an ESOP is adopted.
- Over a 10-year period, ESOP companies have 25% higher job growth than companies without an ESOP.
Getting the Right Guidance
Our most successful clients understand that with large tax and business benefits come complexity and flexibility. However, with the right guidance that helps to provide the right decisions for the right company, an ESOP can be the right solution. Our in-house combination of attorneys and pension consultants, and our history of consulting and strategic planning in the ESOP field are nationally recognized and available to guide you. We will partner with you to determine if, when, whether and how an ESOP may meet your objectives and needs, and execute the right ESOP strategy plan for you and your company.
“It’s not possible to function without a specialist ESOP attorney because there are so many potential wrong turns.”
– Jim Colson, CEO, Building Material Distributors