Business owners planning their succession and leadership transition are taking a closer look at employee ownership models like employee stock ownership plans (ESOPs). But ESOPs aren’t the only employee ownership structure to consider.
ESOP-owned companies and worker cooperatives both offer important potential benefits to employees and business entities. But what should a company owner consider and understand before choosing between the two?
For those keen on democratic worker control, a worker co-op may be the right choice. On the other hand, the significant tax benefits of an ESOP can create a cash advantage that can help the company thrive through the ownership transition and beyond.
Plus, an ESOP’s flexibility may allow for plan governance rules that empower employees with similar rights to create a democratic structure — if that kind of worker control over the business is desired. So it’s important to think about why you’re considering employee ownership, and what might be within reach, before assuming it’s a one-or-the-other choice.
Let’s take a closer look at some of the similarities and differences between worker cooperatives and ESOPs, to get a better picture of the possibilities.
ESOP vs. Co-op: Key Differences
Every ESOP is essentially unique, and the same could be said for worker cooperatives. The most important difference between an ESOP and a co-op is in their definitions:
An ESOP is a federally-regulated employee benefit plan that gives ownership interest to workers by allocating shares from the ESOP trust.
A worker cooperative is a member-owned business entity in which worker-owners have a controlling interest, and who elect the governing body on a one-member-one-vote basis.
Here are a few other significant points of comparison between worker cooperatives and ESOPs:
1. Meaning of “Ownership”
Workers become direct owners of the company.
In a worker co-op, worker-owners have a controlling ownership interest. That is to say, worker-owners make up more than 50% of the total combined voting power of all classes of stock of the corporation.
The ESOP trust is the legal owner of the block of the corporation’s shares (up to 100% of the company) for the benefit of current and future employees.
ESOP employees accrue share allocations while working and typically receive the value of their share allocations, most often in cash, at retirement or separation from service.
2. Voting Rights
Every worker-owner has one equal voting right.
Worker-owners may or may not choose to elect a board of directors, or delegate accountabilities to working groups. These structures can depend on the size of the business.
Employee-owners may or may not have voting rights, as determined and articulated in plan documents. The ESOP-appointed trustee serves on behalf of employee-owners, in most cases.
Democratic governance is neither required nor prohibited.
It’s important to understand that democratic principles don’t always mean every single decision goes to a vote—even in a cooperative. Rather, it’s about shared governance and mutual agreement, and the accountability of management and leadership to the stakeholders. For this reason, both ownership models perform better with in-depth, consistent communication.
3. Employee Eligibility
Criteria for member eligibility in a worker co-op is articulated in governing documents and can include:
All workers who meet eligibility criteria may become cooperative members, but are not required to.
At a minimum, ESOPs are required to cover a substantial percentage of non-highly compensated employees who are at least 21 years old and who have completed one year of service. Certain employees may be excluded from ESOP participation.
ESOP eligibility requirements are subject to IRS nondiscrimination testing, and are articulated in plan documents.
While there are ESOPs with fewer, most have at least 15 to 20 employees, and generally there needs to be enough tax benefit to offset administrative costs. Cooperatives may be a more feasible option for the smallest of businesses.
4. Payment of Dividends to Employee-Owners
|In a worker cooperative, a majority of allocated earnings (i.e. the portion of net income designated as surplus) or losses go to worker-members on a patronage basis as described in the co-op’s governing documents.
Not all ESOPs choose to pay dividends, but they may.Dividend payments for an ESOP-owned C corporation may be tax deductible under IRC Section 404(k)(2).
Patronage is described in a co-op’s governing documents, and may be measured in hours worked, wages earned, number of jobs created, or any other measure of value of a member’s labor.
A cooperative pays income taxes on its profits, and worker-owners must be paid “reasonable” salaries subject to payroll taxes (rather than pay whole salaries as patronage dividends to avoid payroll taxes).
Allocation of profits to patronage dividends allows the cooperative to have worker-owners take on some of the tax responsibility as individuals. The 20% federal pass through deduction creates a tax break.
The ESOP-owned portion of an S-corporation is not subject to federal income tax. So a 100% ESOP-owned S corporation pays $0 in federal income taxes.
An ESOP-owned C corporation can benefit from the tax deductions mentioned above.
|In most cases, workers each contribute a buy-in amount (i.e. each purchases a voting share), and the cooperative secures a loan for the rest of the sale price. Member equity is rarely enough to cover the sale price. Seller notes are commonly part of the sale structure.
|Leveraged ESOP sales often involve a combination of lender and seller financing. Employees do not “buy into” plan participation. Non-leveraged (at sale) ESOPs are rare, but in those cases, the company would contribute the cash to the ESOP, and the ESOP would purchase company shares.
In both cases, lender financing requires valuation by a professional with industry expertise. It can be helpful to work with a lender that’s also experienced in financing employee-owned business conversions, but this is certainly not a requirement.
What If You Want to Integrate Aspects of Both?
Both of these employee ownership models have a lot to offer in terms of transforming the business landscape, and it’s important to take time to reflect on the values driving you to consider who will own your business after you do. When selling to an ESOP or a worker co-op, the seller can exercise considerable control over his or her business exit and choose to stay on as an employee-owner. That means both options can enable a smooth transition.
But what if the ESOP option’s considerable tax advantages and increased cash flow would make a major difference in the ongoing growth and success of the business post-transition?
In that case, remember, an ESOP offers considerable flexibility in plan design. Your first step should be to consult with an expert to explore the ways an ESOP can help you achieve the professional legacy you envision. Not 100% confident that your business is a good fit for an ESOP? It’s easier to find out than you might think. Start with our quick and easy quiz, Is an ESOP Right for You? Just click below to get started.