ESOP Advisory

An ESOP, or Employee Stock Ownership Plan, is a tax-qualified retirement plan that provides employees a beneficial ownership stake through the sponsoring employer’s qualified securities, most commonly common stock. ESOPs are tax-qualified retirement plans and therefore subject to provisions from the IRS and the Department of Labor.

During an ESOP transaction, a trust is established to purchase, either from the company or owner, shares to later redistribute to employees based on pay or another equitable formula. The initial purchase of an owner’s shares is often funded by utilizing a loan to make the initial purchase, some popular options include senior debt financing via a bank and seller financing, with shares being distributed as they are paid back by the trust. It is important that a company interested in transitioning to an ESOP consider Repurchase Obligations prior to establishing a trust.

For a selling owner, there are a number of attractive elements for using an ESOP. An owner can dictate their future role with the company more readily than if selling to a third-party, as well as has the peace of mind knowing that the new ownership both values and has incentive to grow the business. Financially-speaking, a selling owner will receive a fair value for shares as determined by an outside, independent appraiser. This value is determined by multiple factors, but is approximated to be the same as what a financial buyer might pay rather than a strategic buyer.

Even if an ESOP owns a majority of the company, the Board of Directors appoints management to run day-to-day operations. An ESOP’s trustee votes for Board members and serves a fiduciary role to the ESOP Trust. In the event of major corporate changes, a trustee may use pass-through voting to give employees the ability to vote their held shares, however the trustee does retain veto power.

ESOP distributions are taxed as regular income, but employee stock purchases (IRA vs. cash paid) and employer stock contributions are both bought and received on a pretax basis.

The fate of an acquired ESOP depends on purchasing company and what avenues are made available for transition of shares within the new company structure. If the purchasing company is another ESOP, it is likely that shares will roll over into the purchaser’s ESOP. The value will ultimately accrue to shareholders.

There are some cases where the purchaser will cash out shares for their Fair Market Value (FMV) to distribute the proceeds to the ESOP trust. Ordinary income tax and capital gains taxes will be accessed with a lump-sum distribution in addition to a 10% penalty tax if the plan participant has not yet reached retirement age (59 ½ years). If rolled over, the penalty is limited to ordinary rates.

Distributions from ESOPs may be rolled over into an IRA or 401(k) plan. Additionally, an ESOP may be diversified after an ESOP participant has reached 55 years old and has participated in the plan for 10 years minimum. Up to 25% of the stock allocated may be diversified during a 5-year period with the number jumping to 50% during the sixth year.

Many of the ESOP companies in the United States are previously family-owned businesses, but an ESOP is not for every company. Boulay recommends an ESOP Feasibility Study for owners to determine if an ESOP is a right fit.

An ESOP is a vehicle for retirement savings that provides potential growth through the company’s stock value. However, many ESOPs also offer more traditional 401(k) investment plans that encourage employees to diversify their assets as a measure of best practice for financial security.

An ESOP is a poor fit for companies that are either A) financially unstable or whose financial projections show lack of future growth and/or are B) unable to appropriately manage the plan after its creation. ESOPs require expert administrative and internal accounting professionals to properly manage both their external legal requirements and obligations to internal stakeholders. If a company is not committed to establishing a Trust that can effectively manage its fiduciary duties, particularly organizations that frequently experience financial volatility, start-ups, or businesses with less than 25 employees, then an ESOP is not the right purchasing solution.