What is an ESOP?

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

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.

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.

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.

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.