How Does an ESOP Work as a Qualified Benefit Plan & More? [VIDEO]

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Tue, Oct 26, 2021
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Many business owners interested in exploring their options for exit strategies are intrigued by the possibility of selling to an employee stock ownership plan, or ESOP.

When employees learn that the company where they’ve worked for years will become an ESOP, they may wonder, how do ESOP plans work — and how does this qualified retirement plan have the potential to benefit them?

Maybe you’ve heard some confusing or conflicting advice about what an ESOP is, how ESOPs work, and whether they’re a good choice for the seller, the company, and the employees.

Watch this brief explainer video for an introduction to the basics: what an ESOP is, how ESOPs work, how they compare to third-party sales, and their benefits to all company stakeholders.

Video Transcript: What is an ESOP?

An employee ownership plan, or ESOP, is a business transition tool and qualified retirement plan that buys, holds, and sells company stock for the benefit of its employees, providing them with an ownership stake in the company.

The Mechanics: How an ESOP Works

To set up an ESOP, you’ll establish a trust to buy your company stock. Each year, you’ll make tax-deductible contributions of company shares, cash for the ESOP to buy company shares, or both. The ESOP trust will own the stock, and shares will be allocated to individual employees’ accounts over time.

Funding

The purchase of stock for the ESOP can be funded in many ways, but usually involves a loan, either from a bank or the selling shareholders. Employees, in most cases, pay nothing, either upfront or on an annual basis — and management continues to run the company.

The company makes tax-deductible contributions to the trust each year, which the trust uses to repay the loan it was given to acquire the stock or allocate it to participant accounts.

Shares to participants are allocated based on a formula, like payscale; as employees accumulate seniority, they acquire an increasing right to the shares in their accounts.

Employees get paid the value of their individual account after they leave your company. The company typically hires a third-party administrator to administer the plan in accordance with regulations related to vesting, benefit distribution, coverage, compliance testing, and other requirements.

How Does an ESOP Compare to Third-Party Sales?

A third-party sale of a business would likely involve escrow payments, holdbacks, and earn-outs. Selling to an ESOP for full payment minimizes these drawbacks, and because it’s a stock sale, it’s more favorable from a tax standpoint.

And, the company can be bought at full fair market value.

The Benefits of an ESOP: Advantages to the Seller, the Company, and its Employees

Currently, a 100% ESOP-owned S corporation has zero federal tax liability. The tax savings can largely provide the cash flow to fund the purchase of the stock from the selling shareholders, fund the repurchase obligation going forward, and increase cash flow, leading to a competitive advantage. 

An ESOP fosters an ownership culture that encourages employees to think and act like owners, enhancing job satisfaction, employee retention, and recruitment.

An ESOP rewards employees, saves local jobs, and strengthens the community.

Ready to learn more? Reach out to ESOP Partners for a no-cost feasibility analysis.

Learn More About the Benefits of ESOPs

It’s easy to dig in deeper and get a more detailed understanding of an ESOP’s advantages to all stakeholders in your business. Company owners, key leaders, employees, and even the community at large all stand to benefit from the decision to form an ESOP company. Learn more about the most important ESOP benefits when you download our free eBook, Key Benefits of Incorporating an ESOP into Your Business Strategy. Just click below to claim your copy.

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Topics: Employee Stock Ownership Plan (ESOP), ESOP, ESOP Planning

Aaron Juckett, CPA, CPC, QPA, QKA
Written by Aaron Juckett, CPA, CPC, QPA, QKA

Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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