How an ESOP can help your business and empower your employees

Entrepreneurs who deeply value their employees and recognize their critical role in their company's success can unlock even greater potential by leveraging an employee stock ownership plan. ESOPs offer numerous advantages, including tax breaks, increased employee motivation, and an efficient transfer of ownership.

While not suitable for every entrepreneur, an ESOP holds the potential to create value for your business, employees, and you.

Understanding the ESOP mechanism:

An ESOP serves as a tax-qualified retirement plan that enables employees to gradually acquire a portion or the entirety of your company's stock. Consequently, employees become beneficial owners, and the company becomes partially or entirely employee owned.

Setting up an ESOP involves establishing an employee stock ownership trust and making annual contributions in the form of cash or company stock. Since an ESOP is a retirement plan, these contributions are tax-deductible, and employees are not taxed on their shares until they receive distributions. Each employee has an account within the ESOP, and shares are allocated based on factors such as salary, years of service, or job title.

When vested employees leave or retire, the company is obligated to repurchase their shares at the most recently determined share value. The distributions can be made in a lump sum or through installment payments, depending on the ESOP's structure.

Unique features of ESOPs:

ESOPs possess distinctive characteristics compared to other employee benefit plans, including:

1. Investment in employer stock: ESOPs are allowed to primarily invest in the employer's stock.

2. Borrowing capability: An ESOP can borrow money on the employer's credit to purchase the owner's shares. The company then makes contributions to the plan, which are tax-deductible and used to repay the loan. This feature positions ESOPs as valuable corporate finance tools.

3. No employee contributions: Unlike plans like a 401(k), employees don't use payroll deductions or their own contributions to acquire company stock.

Unlocking tax benefits:

ESOPs can provide impressive tax advantages for both companies and owners. These benefits include:

1. Deductible ESOP contributions: Annual cash contributions to the ESOP are generally tax-deductible, up to 25 percent of covered payroll, which includes employer contributions to other defined contribution plans.

2. Deductible principal and interest payments: ESOPs enable borrowing to buy shares, with the company's contributions used to repay the loan. These contributions, covering both principal and interest, are tax-deductible.

3. Tax-free income: Certain ESOPs, such as those in S corporations entirely owned by the ESOP, can avoid federal income taxes altogether. By eliminating tax obligations on the company's income, significant cash flow becomes available for other purposes.

4. Deferred capital gains taxes: In the case of a C corporation, selling at least 30 percent of your stock to an ESOP allows for deferring capital gains tax on the profit. By electing a Section 1042 exchange and reinvesting the stock sale proceeds, you can postpone the gain until selling those replacement securities.

Building a stronger business:

By granting employees a stake in your company through an ESOP, you can enhance their motivation and commitment, leading to improved business performance.

Employee Owners’ Jobs More Stable in a Nervous Economy. The Employee Ownership Foundation today focused on convincing evidence from the most prestigious social survey in the U.S., the General Social Survey (GSS), that showed employees in the U.S. who had employee stock ownership were four times less likely to be laid off during the Great Recession than employees without employee stock ownership.

Specifically, the 2010 GSS, funded primarily by the National Science Foundation and conducted by the National Opinion Research Center at the University of Chicago, found that 3% of employees with employee stock ownership, which include the ESOP model and other forms of employee ownership, were laid off in 2009-2010 compared to a 12% rate for employees without employee stock ownership.

ESOPs also have the potential to aid in recruiting and retaining top talent. Employees won't pay income tax on stock put into their ESOP accounts until they receive distributions, typically upon leaving the company or retiring. Although early distributions may incur a 10% penalty in addition to income tax, the funds can be rolled into an IRA or another qualified plan, continuing the tax deferral.

Smoother succession planning:

Given ESOPs' ability to help selling shareholders defer or even avoid capital gains taxes, they have become vital components of many entrepreneurs' succession planning efforts. With approximately 6,500 ESOPs in the U.S., according to the National Center for Employee Ownership, their popularity continues to grow.

ESOPs offer advantages in terms of smoother, less volatile transitions compared to selling to potentially strategic buyers. An employee sale can foster greater stability in employee retention as the staff themselves take over. Additionally, an employee sale often reduces the need for extensive presale preparation before the transition.

Considering an ESOP:

While the benefits of ESOPs are significant, they may not be the ideal option for all entrepreneurs. Assessing your goals and situation, both personally and as a business owner, is crucial in determining whether an ESOP is worth considering.

Factors to consider include:

1. Goals: Determine if selling your business to employees aligns with your vision. Assess whether you have the talent in place to ensure the company's smooth operation after your departure or if you would need to recruit new staff or invest in developing existing personnel.

2. Company Size and Financial Picture: Consider the size of your business and its financial health in relation to the cost of setting up an ESOP. Typically, a minimum of 25 employees and annual EBITDA of around $3 million or more is necessary to make an ESOP financially viable. Larger firms often have better access to financing for purchasing shares.

3. Liquidity Issues: Be aware that if the value of your company's stock significantly rises, the ESOP may face challenges repurchasing stock when employees retire, especially if multiple employees retire simultaneously. This could strain the company financially.

4. Succession Planning Timeline: ESOP ownership transitions are recommended to occur over a period of five to ten years. If this timeline seems too lengthy, an outright sale to a third party may provide a faster cash-out option.

5. Payout Considerations: Legally, an ESOP cannot pay more for company shares than their fair market value, as determined by an independent valuation specialist. Selling to a third party may potentially yield a higher payout. Evaluate the maximum potential payout against the benefits of selling to dedicated employees who share your business values.

6. Business Structure: ESOPs can be set up only in C or S corporations, not partnerships or most professional corporations

If an ESOP sounds intriguing, consider working with a financial advisor that holds the CERTIFIED FINANCIAL PLANNER™ professional designation specializing in government contractor business transitions.

They can help conduct a feasibility designation to assess how an ESOP and the associated transactions could align with your specific business. You may discover that an ESOP is a suitable option for your company or that taking certain steps in the right direction can make it a viable choice.

Jamie Waldren is managing director of investments for Wells Fargo Advisors in Columbia, Maryland. He has experience navigating the implementation of an ESOP. He can be reached at 410-715-5026 or via email at jamie.waldren@wfadvisors.com.

Wells Fargo Advisors is not a legal or tax advisor.