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What Does ESOP Stand For?

ESOP stands for Employee Stock Ownership Plan. An ESOP is a qualified retirement plan that can be used by a corporation as a:

Business Transition Tool. An ESOP is often used as a business transition tool (also referred to as an exit strategy) that establishes an ESOP trust to be an ongoing perpetual owner of the company. About two-thirds of ESOPs are used to provide a market for the shares of a departing owner of a profitable, closely held company.

Employee Ownership Vehicle. An ESOP is an employee ownership vehicle, allowing the company to provide employees with an ownership stake and benefit from its success.

Qualified Retirement Plan. ESOPs are qualified retirement plans, similar to 401(k) plans. An ESOP buys, holds, and sells company stock, providing employees with a retirement plan benefit and additional form of compensation.

As employee ownership vehicles and qualified retirement plans:

  • Contributions to the plan are tax-deductible
  • Employees pay no tax on the contributions until they receive the stock when they leave or retire
  • They then either sell it on the market or back to the company
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What Kinds of Companies Sell to ESOPs?

As of 2020, it’s estimated that in the U.S. there are approximately 6,600 ESOPs covering more than 14 million participants. A company doesn’t have to be big to sell to an ESOP, though some that have are well-known large enterprises, such as Publix Super Markets, W. L. Gore Associates (the makers of Gore-Tex), and Amstead Industries. Companies with ESOPs and similar employee ownership plans account for more than half of Fortune Magazine's "100 Best Companies to Work for in America" list year after year.

A search of your region will show that many companies familiar to you are in fact ESOPs.

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The Benefits of an ESOP to Employees

Employees benefit in a number of ways, both monetary and culturally.

  • ESOPs increase employee wealth and wages
  • ESOP companies provide more sustainable employment
  • S Corporation ESOP companies have been shown to be more stable, and to lead to greater job satisfaction and higher organizational commitment
  • ESOPs outperform 401(K) plans by 19%, making it a preferred retirement option

As company owners, employees often feel a greater sense of commitment to the ongoing success of the organization because they understand that their contributions impact results. This ownership thinking can make a meaningful difference in their attitudes and quality of work.

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The Benefits of an ESOP to Corporations

The benefits to corporations make an ESOP a “no brainer” for many; there are tax, cash flow, productivity and revenue benefits.

  • One study found that ESOP companies had sales growth rates 3.4% per year higher and employment growth rates 3.8% per year higher. Other studies report sales growth of 3.8% and 2.4% and employment growth of 3.4% and 2.3%
  • ESOP companies that were also participatively managed grew 8% to 11% per year faster than they would have been expected to grow

As company owners, employees often feel a greater sense of commitment to the ongoing success of the organization because they understand that their contributions impact results. This ownership thinking can make a meaningful difference in their attitudes and quality of work.

The 2010 General Social Survey (GSS) found that employee ownership results in lower turnover and fewer layoffs, as employees were four times less likely to be laid off and less likely to leave a company – a sign of solid productivity and revenue. Other research has found that:

  • Employee ownership increases innovation, likely due to having the cash flow to invest in technology and equipment
  • ESOPs enable a business owner to sell his or her company in 60-90 days with a built-In buyer, providing diversification and liquidity; at the same time, the business owner can retain control of the company
  • ESOPs increase the after-tax proceeds of the sale for the seller, providing greater overall return than a private sale
  • The cost of the sale is offset by tax benefits: ESOPs eliminate company income tax obligations
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READ MORE ABOUT ESOPS BY REVIEWING THE RESOURCES BELOW:
HmPg-CTA-Right for Your Company
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How Does an ESOP Work?

The “mechanics” of an ESOP are, to an extent, unique to the company selling to its employees, and the variations in sales depends on several factors. For the sake of simplicity, we’ll explain a basic structure:

  • The company sets up a trust fund for employees, and contributes either cash to buy company stock, contribute shares directly to the plan, or has the plan borrow money to buy shares
  • If the plan borrows money, the company makes contributions to the plan to make it possible to repay the loan
  • Contributions are tax-deductible, and employees pay not tax on their contributions until they receive the stock when they leave the company or retire; at that time, they either sell it on the “market” or back to the company

Watch this video for more detail about the options companies have in setting up their ESOPs.

 

ESOP transactions are handled differently by different ESOP consultancies, but our method, called the Succession Advantage™ Ownership Transition Process, is among the fastest methods for completing a business transition and realizing the benefits. A traditional business sale can take up to 2 years to complete, compared to just 90 days when you sell to an ESOP with ESOP Partners, meaning sellers see cash sooner and start reaping the tax benefits sooner.

The steps involved in selling to an ESOP are straightforward, and each is critical to the long-term success of the plan.

Step #1: No-Cost Feasibility Analysis

Our process begins with a feasibility consultation that will tell you if an ESOP is a viable solution based on your business.

Is An ESOP Right For Your Company

Step #2: Feasibility Study

If it’s determined that an ESOP may be a viable solution, modeling is done to understand what the sale could mean for the company, its management and its employees. This study also models what an ESOP would look like from the following perspectives:

  • The company. Identify how the ESOP will impact the company’s cash flow and financial statements
  • The selling shareholder(s). Outline all disbursements to the selling shareholder such as cash payments, financing, tax deductions, tax payments, synthetic equity payments, and ESOP balances (to the extent each applies)
  • The management. Articulate how the ESOP can be used to reward and incentivize key management and also for retention and recruiting
  • The participants. Modeling the employee benefit level the plan will provide

Step #3: Preliminary Valuation

This step is the point at which the value used in the modeling is confirmed by an independent valuation firm.

Step #4: Implementation

In this final step we offer guidance through the transaction closing and actual sale of stock to the ESOP. This includes developing the plan design (who is in the plan, when they get in the plan, when they get paid and how they get paid) and a communication strategy for employees, vendors, clients and the marketplace in general.

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What are the Roles and Responsibilities of an ESOP Trustee?

The ESOP Trustee is an integral part of the ESOP Corporate Governance process. An ESOP Trustee serves as the legal shareholder of the shares held by the ESOP trust. This professional has several responsibilities; among them are:

To vote ESOP shares to select the Board of Directors.

As the legal shareholder, the ESOP is responsible for voting the ESOP shares in most cases, including selecting the Board of Directors. The ESOP plan document specifies the voting rules for each individual plan.

To manage the assets of the ESOP trust.

The ESOP assets, which primarily consist of the stock of the company, are required to be held in a trust and managed by the ESOP Trustee. The ESOP Trustee is the individual with authority and discretion over the plan assets, and this includes developing an investment policy of both cash and stock investments.

To establish the annual ESOP stock price.

One of the most important fiduciary responsibilities of an ESOP Trustee is to establish the annual ESOP stock price. This starts by making sure the ESOP appraiser is independent, both in fact and appearance, and that they have relevant and significant ESOP experience.

To follow Plan documents.

A fiduciary is required by ERISA to act in accordance with the plan documents. This means that the ESOP Trustee must fully understand the plan and trust documents.

To satisfy ERISA fiduciary responsibilities.

The ESOP Trustee is an ERISA fiduciary that has primary duties defined in ERISA. He or she must act solely in the interest of the plan's participants and beneficiaries while defraying reasonable plan expenses and acting in accordance with the plan documents.

To document the process.

The process of making a fiduciary decision is just as important as the result of the process, and should be clearly defined and executed as planned.

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What Does the ESOP Board of Directors Do?

The job of a Board of Directors is to develop and execute long-term, strategically focused decisions in line with corporate governance best practices. Board members are elected by the Shareholders to oversee the direction of the company and protect the interests of the Shareholders. The Board represents the highest level of management in the company and has a fiduciary obligation under state law to the shareholders.

An ESOP Board of Directors has three primary areas of responsibility:

GROW SHAREHOLDER VALUE
Protect and grow the Shareholders’ value and carry out the mission and values of the company. The Board has a fiduciary duty of care to act prudently, and a fiduciary duty of loyalty to act in good faith and in the interest of the company and to all of its shareholders. This must be done while satisfying the fiduciary duty of obedience to remain faithful to the purpose of the company.

SUCCESSION PLANNING
The Board is responsible for ensuring that a succession plan is in place for the CEO and key senior members of management. This includes developing and training replacements internally and selecting external candidates when appropriate.

ADVISE THE CEO
The Board advises and sets strategic goals for the CEO by approving financial statements and making significant cash decisions and strategic decisions.

CORPORATE GOVERNANCE
The Board must fulfill its responsibilities in accordance with state law, Articles, Bylaws, and other governing documents and regulations.

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READ MORE ABOUT ESOPS BY REVIEWING THE RESOURCES BELOW:
Mechanics of an ESOP Transaction Infographic
Company BOD Responsibilities Tip Sheet
Corporate Governance eBOOK
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ESOP Taxation

Do ESOP Companies Pay Taxes?

We often get asked, “Is it true that S Corporation ESOP companies are not subject to income taxation?”

The ESOP trust is an S Corporation shareholder that is a tax-exempt entity not subject to income taxes. S corporations are pass-through entities that pass through their corporate income to their shareholders for federal and state income tax reporting purposes. Each year the shareholders receive an IRS Form K-1 and report the flow-through of the income on their personal tax returns based on their individual federal and state income tax rates.

This is a powerful tax advantage that provides the cash flow for an ESOP to purchase the company from the selling shareholder(s). Once the stock purchase has been completely funded, the additional cash flow resulting from the tax savings provides a company with a cash flow competitive advantage over their non-ESOP counterparts.

S corporations are not exempt from all taxation, however. The ESOP shareholder is tax-exempt, not the corporation. To the extent the corporation is directly subject to taxation, such as property taxes, the corporation is still responsible to satisfy the tax obligations. In addition, if a state has an income tax on S corporations, the corporation is still responsible for the income tax.

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READ MORE ABOUT THE TAX BENEFITS OF ESOPS BY REVIEWING THE RESOURCES BELOW:
HmPg-CTA-Succession Adv eBook
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ESOP Distribution

ESOP participants receive benefits after leaving employment. Distributions are made in the form of cash, stock, or a combination of both. They can be made once, as a lump sum, or split into generally equal payments of no more than five years.

ESOP companies that follow best practices develop a written distribution policy, helping demonstrate that they’re operating their ESOP distribution policies in a nondiscriminatory manner; it also gives the company more flexibility to modify the distribution policy in the future. Distribution policies must comply with the statutory minimum requirements from the Internal Revenue Code.

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READ MORE ABOUT DISTRIBUTIONS BY REVIEWING THE RESOURCES BELOW:
ESOP Distribution Policy eBOOK
No Cost Repurchase Liability Consultation
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What Does An ESOP Plan Administrator Do?

In a nutshell, it’s the job of your plan administrator to make sure your plan stays in full compliance at all times. That requires foresight, knowledge of rules and regulations related to ESOPs, and of the compliance testing specific to ESOPs.

 

The best plan administrators look at the long-term objectives of the ESOP, and keep a close eye on the repurchase obligation to prepare for fulfilling it. The goal is to maximize the potential and optimize the performance of the ESOP.

Another aspect of a good plan administrator is their focus on people. Employee ownership creates an ownership culture among employees, but that must be fostered, and communications is the key. There’s also a fair amount of discussion as the sale happens, helping participants understand the process and what it means for them.

It’s critical in choosing a plan administrator to pick one with specific ESOP skills, like ESOP Partners; just because someone does 401(k) administration doesn’t mean they’re the most qualified to do ESOP administration. You need a partner that:

  • understands ESOP administration and ESOP compliance testing and how it works
  • understands the big picture of an ESOP lifecycle and really of a company lifecycle
  • is going to look for ways you can use your ESOP to help your company grow — someone who’s going to be looking out for your long term valuation is headed

What About the Repurchase Obligation?

The ESOP repurchase obligation or liability is the company’s obligation to buy back shares from ESOP participants according to the company’s ESOP plan document and ESOP Distribution Policy. The ESOP repurchase obligation helps with planning for cash requirements and how to meet bank (or seller) requirements for leveraged ESOPs.

The obligation is created by the ESOP put option – the right to demand employer securities provided under IRC Section 409(h).

The ESOP put option creates a call on the company’s cash flow. An ESOP repurchase obligation forecast or study is a long-term projection of the call on company cash needed to satisfy the plan’s ESOP distribution requirements. The results of the forecast are dependent on the participant data/demographics of the employee population, the ESOP Repurchase Obligation Forecast Assumptions, and the ESOP Distribution Policy. In addition to corporate and ESOP planning, the repurchase obligation forecast will help quantify the projected ESOP repurchase obligation for financial statement reporting and stock appraisal purposes.

Culture & Communications

Employee ownership is the basis of a unique culture, and one that’s a distinct differentiator when it comes to attracting and retaining talent. A 2019 analysis conducted by the Institute for the Study of Employee Ownership and Profit Sharing at Rutgers University found that 72% of respondents surveyed would rather work for an employee-owned company than one owned by conventional shareholders or the government. Also, turnover at employee-owned companies is three times lower than at conventionally owned businesses.

The role of communications is both critical in nurturing to the ownership culture and, during the process of selling, takes on the role of change management – helping manage the expectations of the people going through the ESOP sale. Creating and sustaining an ownership culture and communicating regularly with plan participants is critical in the long-term success of the ESOP.

It’s important that people understand the “why” behind selling to an ESOP, and that they are attuned to the kinds of improvements being made as a result – improved cash flow which translates to the ability to purchase new equipment, for example.

Communications can take many forms: events, notifications, newsletters, emails, videos and others. The goal is to provide as much transparency as is practical, and promote the benefits of the sale. Communication from employees to management is key, too, allowing this team to understand how employees are perceiving the sale.

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READ MORE ABOUT THESE TOPICS BY REVIEWING THE RESOURCES BELOW:
Repurchase Obligation Forecasting Reporting Funding
Communications Committee eBook
Culture and Communications eBook
Launching and Relaunching Your ESOP Infographic

Whether you’re considering an ESOP or are already an ESOP company, we can help! Schedule a conversation with a member of our team today.

ESOP Consultation