An Employee Stock Ownership Plan (“ESOP”) is a type of defined contribution benefit plan in the U.S. that buys and holds company stock. ESOPs are most often used in closely held companies to buy part or all of the shares of the existing owners. This provides a tax-deductible market for the acquisition of shares of Company stock from existing shareholders.

An ESOP is a tax-exempt entity (technically, a trust) for Federal and state corporate income tax purposes, enabling a Company to make cash and/or Company stock contributions to the trust, which are then used to acquire stock of the Company on behalf of its employees. Because a Company’s Board of Directors appoints the Trustee, the Company can retain a measure of control.

 

What are the Benefits of Establishing an ESOP?

ESOPs offer many benefits, and, as they say, “beauty is in the eye of the beholder.” To a private company shareholder, an ESOP is a buyer of stock; to an employee, it is a company funded retirement plan; and to the company it is a technique of corporate finance. More specifically, an ESOP can be used to:

• Provide a private company’s shareholders with a valuable diversification vehicle in order to avoid having the overwhelming majority of their net worth invested in company stock.
• Provide a tax-deductible and flexible in-house market for the acquisition of shares of company stock from existing shareholders.
• Provide a funded plan for the succession and transition of the business.
• Decrease the company’s income tax liability, thereby enhancing its cash flow for continued growth and debt reduction.
• Provide a means whereby the employees of the company will be able to acquire a beneficial interest in the company such that the employees will have a direct interest in the success of the business.
• Borrow money for the stock purchase and repay the entire loan with pre-tax dollars.
• Attract, retain, motivate and reward productive employees.

 

What Kind of Company is a Good ESOP Candidate?

The following are some common characteristics of companies who choose to implement ESOPs.

• Private companies that have major or minor stockholders who wish to cash out, either immediately or over a period of time.
• A company whose stockholders are of different ages with different exit time frames.
• A company whose stockholders want to diversify their net worth by selling part of the company, but not necessarily relinquish control of the business.
• A company that wishes to increase working capital and cash flow.
• A company owner who wants to make way for successor management, such as working heirs or other key executives.
• A company that has major stockholders who wish to indefinitely defer payment of the capital gains taxes on the sale of company stock.
• A company owner who may wish to transfer ownership to employees, tax free, in lieu of other benefits.

 

Other Considerations

In order to successfully implement an ESOP stock transaction, a company should be profitable, with at least 15 full-time employees. If you meet these criteria, especially if you already maintain a profit sharing plan or a 401(k) plan, you should definitely consider establishing an ESOP. By establishing an ESOP, you can create a tax-deductible, in-house market to give you liquidity for your own stock if and when you choose to sell some shares. Under certain conditions, you can even sell tax free.

Finally, employee ownership does not necessarily lead to a loss of control. Regardless of how much stock the ESOP acquires, you will still indirectly be able manage your company. The Board of Directors of a company appoints a trustee to vote the stock in the plan. Thus, control can continue as it is right now, or change as the Board sees fit. Remember, the employees do not directly own the company stock - employees are beneficiaries of the economic value of the trust's investments; the ESOP trust owns the stock.

 

Learn More About ESOPs

 

We'd like to help you understand more about ESOPs.

 

Visit our Online Library to read more about ESOPs, browse our "Frequently Asked Questions," review our Case Studies, or watch our webcasts on various topics ranging from Auto Dealers to Corporate Governance.

 

In addition to these resources, we encourage you to visit the websites of the National Center for Employee Ownership and The ESOP Association - the premier industry organizations devoted to employee ownership and ESOPs.

Click here to visit the NCEO's website!

 

Click here to visit The ESOP Association's website!