Q and A: Is an ESOP Right for Your Company?

April 10, 2023 | Experts Agree: Iowa's Business Climate is Improving Debra Linder, Shareholder, Fredrikson, dlinder@fredlaw.com

More business owners are nearing retirement and need a plan for the succession of their company. While various options are available, including a sale to a strategic buyer or private equity, owners may want to consider employee ownership through an employee stock ownership plan (ESOP). This article will provide general information about ESOPs and highlight some of the issues that business owners will need to consider when exploring that option. 

What is an ESOP?

An ESOP is a type of qualified defined contribution plan, like a profit sharing plan, that is designed to invest primarily in “qualifying employer securities.” Generally, “qualifying employer securities” are shares of common stock issued by the company.

Who is a typical ESOP candidate?

The typical ESOP candidate is a C or an S corporation that has a stable workforce that is motivated by the potential growth in the company’s value. Usually, the owner(s) are nearing retirement age and have a strong management team in place to take over the day-to-day running of the company. Finally, the owners must be willing to embrace an employee ownership culture, which includes sharing information about the company’s financial performance. 

What rules apply to an ESOP?

As a qualified plan, the ESOP must comply with numerous requirements imposed by the Internal Revenue Code of 1986 and The Employee Retirement Income Security Act of 1974 (“ERISA”). For example, the investment of employees’ retirement accounts in company stock must satisfy ERISA’s fiduciary standards, which require that the investment is prudent and for the exclusive benefit of employees and their beneficiaries. The ESOP also must comply with many of the same eligibility, vesting and nondiscrimination requirements, compensation limits and deduction limits that apply to other qualified retirement plans.

Special rules also apply to an ESOP. For example, employees approaching retirement have the right to diversify the investment of their accounts in the ESOP. An employee who is age 55 and who has 10 years of participation in the ESOP may diversify 25% of his or her account into other investment options, with that percentage increasing to 50% at age 60. In some cases, employees have the right to receive distributions from the ESOP in the form of stock, which they can then require the company to repurchase. Distributions of employees’ accounts usually occur over a five-year period; however, some ESOPs permit a lump sum distribution if the account is under a specified dollar amount. Finally, the shares held by the ESOP must be valued at least annually by an independent appraiser. 

Who votes the shares held by the ESOP?

In most cases, the trustee of the ESOP votes the shares, such as for the annual election of the board of directors. But, for major corporate events, such as a merger or a sale of the company’s assets, the employees have the right to vote the shares held in their accounts. 

Is setting up an ESOP expensive?

Because ESOPs are heavily regulated by the IRS and the Department of Labor, it is critical to have experienced financial and legal advisors involved in the design of the ESOP and the structure of the ESOP transaction. As a first step, the company and selling shareholders often engage a financial advisor to do a feasibility study and develop alternative transaction structures. If they decide to move forward, an independent trustee will be appointed by the company’s board of directors. The trustee will hire its own valuation expert and legal counsel, who will evaluate the company and negotiate the terms of the transaction. The company will need to engage experienced legal counsel to negotiate the transaction and create the necessary documents. Finally, the selling shareholders may want their financial advisors to review the transaction terms. Consequently, the initial set up of an ESOP can be expensive.

Going forward, the ESOP must have its shares valued by an independent appraiser at least annually. The company often retains the independent trustee, who must comply with ERISA’s fiduciary requirements. The company will also need to engage an experienced third-party administrator to ensure compliance with the various IRS rules and help the company manage the ESOP’s cash flow needs. While these fees can be a bit more expensive than the typical 401(k) or profit sharing plan, the advantages often outweigh those additional costs.

What are some of the advantages of an ESOP? 

Allowing employees to share in the company’s profits and financial growth can improve their motivation and productivity. An ESOP can also provide a ready market for selling shareholders, as well as a tax-favored source of capital for acquisitions and expanding the business.

If certain conditions are met, the selling shareholders can defer all or a portion of the gain on the sale of their stock by reinvesting the proceeds from the sale in “qualifying replacement securities” through a “1042 rollover.” And, for S corporations, the portion of the company’s net income that is allocated to the ESOP is not subject to income tax, allowing the company to use that cash for expansion or other business needs.

What are some of the disadvantages of an ESOP?

The company will need to carefully consider and project the ESOP’s cash flow needs. For example, the ESOP usually finances the purchase of employer securities with a loan, and the payments on that loan are made from tax-deductible contributions made by the company. The ESOP will also need cash to fund employees’ distributions and diversification elections, and that cash must come from either contributions or dividends made by the company to the ESOP.

In addition, the ESOP may be subject to restrictions on how the shares are allocated. For example, the family members of selling shareholders who elect a 1042 rollover cannot receive an allocation of shares inside the ESOP. And, an ESOP sponsored by an S corporation is subject to complex rules designed to ensure broad participation, rather than having the ESOP’s shares concentrated in the hands of a few.

Where can I find more information?

Business owners who are interested in exploring an ESOP can find a wealth of information through The National Center for Employee Ownership (https://www.nceo.org/), The ESOP Association (https://www.esopassociation.org/) and the Iowa-Nebraska Chapter of The ESOP Association (https://www.esopassociation.org/chapters/iowa-nebraska). These organizations maintain an extensive library of publications explaining nearly every aspect of ESOPs and employee ownership, and sponsor several meetings throughout the year where business owners can learn about other ESOP companies’ experiences.

In summary, with thoughtful planning, an ESOP can provide a great alternative for a business owner to consider when it is time to sell. At the same time, selling the company to the employees through an ESOP can preserve the company’s culture, reward employees for their contributions and efforts in the company’s success and, at the same time, enhance employees’ retirement benefits.