Q&A: Is an ESOP the Right Choice for Your Business?

Let’s explore the definition of an Employee Stock Ownership Plan (ESOP), their popularity, reasons to consider pursuing this option and next steps you can take.

What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is a qualified benefit plan that is established when a business owner sells all or a portion of their share in the business to an ESOP Trust. Employees receive shares in the company, and selling ownership receives a buyer for the company and a succession strategy to pass ownership to the next level of management.

Are ESOPs popular?

According to the National Center for Employee Ownership, there are more than 6,500 unique ESOPs in the United States, employing 10.7 million people with total assets of more than $2.1 trillion. ESOPs are popular among small- and middle-market businesses. The top five most common industries among privately held ESOP companies are Professional Services, Manufacturing, Construction/Contractors, Finance/Insurance and Wholesale Trade.

Why consider an ESOP?

There are multiple reasons to consider an ESOP for your business, including succession planning, tax advantages, rewarding employees and marketing advantages.

How can an ESOP help with succession planning?

Most companies fall into one of three categories for succession planning:

• 15% will pass the company to a family member
• 20% will sell the company to private equity
• 65% have no immediate solution documented for the next stage of ownership

Management often continues to run the company after the transition to an ESOP to ensure operational and financial stability. Employees will not own shares of the company directly, but they do have a financial interest in the shares allocated to their account.

Transitioning to an ESOP can often be a vehicle to retain and incentivize the next level of management by offering stock appreciation rights (SARs) or attaching warrants—enhanced financial benefits for employees—to the ESOP.

What are the tax advantages of an ESOP?

An ESOP is available for both S-corps and C-corps with different advantages for each. An S-corp is most common, as it allows a company to be exempt from federal income tax on the portion of the company that is owned by the ESOP. For example, if a company is 100% ESOP S-corp, they will be completely exempt from federal income tax.

A C-corp provides the selling shareholder the ability to defer capital gains tax on the sale of the company through a 1042 exchange. While a C-corp does not have the exempt status of an S-corp, certain deductions, such as ESOP contributions, can aid in reducing the company’s tax liability. Additionally, if company ownership wants to transition a C-corp to an S-corp, they can do so after a five-year reporting requirement.

How do ESOPs reward employees?

An ESOP helps protect the independence of a company along with employees’ jobs. If ownership decides to sell to an outside interest, such as private equity or a strategic buyer, often times there are organizational changes that put local jobs at risk. With an ESOP, the current management structure remains in place, and the company can continue to operate free from external influence.

An ESOP raises the benefits for employees across the organization. At no cost to the employees, they receive an additional wealth-building tool for retirement. And, unlike a 401(k), employees are not required to contribute for shares of the company to be allocated to their account. Historically, ESOPs have a higher rate of return compared to a 401(k), and the funds will grow tax-free until distribution.

What are the marketing advantages of an ESOP?

Research shows that companies with employees who think and act like owners tend to be more productive, more profitable, faster growing and have higher retention than their peers. While an ESOP will not transform your company culture, it can certainly enhance an already healthy culture.

An ESOP can attract and retain talent because it is a wealth-building tool for employees. It reinforces a culture of valuing employees by sharing in the company’s success with those who contribute to it through their daily work.

What are next steps to determine if an ESOP is the right fit?

Consider these factors to determine if an ESOP is the right fit for your business:

• Company size: This could be a great option for your company if you have at least 25 employees.
• Cash flow: Your company’s Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) should be in excess of $1 million annually. • Transition fees: Your company would need to cover the cost of setting up an ESOP, which typically exceeds $100,000 and includes the cost of valuation, legal expenses, CPAs and other fees.
• Feasibility study: It might be helpful to conduct a feasibility study to determine if your company can and should become an ESOP. 

Reach out your commercial banking partner or contact me to learn more about ESOPs. ABI