Employee Stock Ownership Plans: Exploring Opportunities for Business Owners

Kevin Jennings, ABV, CVA and Carla Klinger
Published Date:
Jan 1, 2018

An employee stock ownership plan (ESOP) is a qualified retirement plan under IRC section 401(a) that is nondiscriminatory and provides transition opportunities for a company’s owners. But an ESOP is not for everyone—the company must be robust and produce sufficient cash flow to cover the expenditures associated with an ESOP. 

Let’s explore what an ESOP is—and how it might benefit your clients.

What is an ESOP?

An ESOP is a trust that owns the shares in the company as a single shareholder. Only C corporations and S corporations can currently sponsor ESOPs. 

Benefits for the Participants

ESOPs provide an entrepreneurial incentive to its participants. Workers now work for their company. They hold a vested interest in growth in revenues, profits, and value.

ESOPs also provide tax-deferred growth to the participants. The taxable event occurs when the termination distributions are made. As with other retirement plans, this generally occurs when the participant is in a lower tax bracket.

ESOP companies frequently offer more benefits than non-ESOP companies.

Benefits for the Company

Studies comparing companies before and after an ESOP is implemented show

  • a 2.4% increase in annual sales growth
  • a 2.3% increase in employment growth
  • a 2.3% increase in annual sales per employee.

These might look like small changes, but taken over ten years, the ESOP company can be growing as much as 33% more quickly than its non-ESOP counterparts. Further, ESOP companies generally fail less frequently and retain more jobs than non-ESOP companies. This is essential for owners who are being paid by the ESOP over time.

Federal legislation is frequently introduced that increases the desirability of an ESOP.  Current legislation that also benefits owners expands tax deferment of capital gains to include S corporations as more incentive to S corporations to establish an ESOP.  

ESOPs are tax-free entities and shareholders. 

Sales to ESOPs are often less expensive than sales to third parties.

Benefits for the Owner

An ESOP serves as a transition tool—and is one of the few transition tools that allows a minority interest to be transferred and still provide funds back to the owners. Partial or total acquisition by the ESOP of an owner’s shares can occur. The transition can occur in stages over an extended period. 

Owners can remain involved in the management of the company.

The ESOP provides a market for the owner’s interest in the future.

The ESOP can provide liquidity for settlement of estate taxes.

ESOPs introduced in C corporations hold the potential for the selling owner to defer capital gains. Once at least 30% ownership is transferred, the taxation of proceeds is tax deferred if those proceeds are invested in qualified replacement property (QRP). Under IRC section 1042, QRP includes common stock, preferred stock, bonds, and convertible bonds of “operating companies” incorporated in the United States.  As with other IRC regulations, careful reading and working with knowledgeable professionals to ensure the requirements are met is necessary.

A key aspect of ESOPs is that the owner’s legacy continues.  This might also occur with a sale to management or a transition to the next generation, but it might not occur on a sale to a third party.

The Downside for the Participants

There are few drawbacks for the participant. While most companies continue other benefits and retirement plans, such as a 401(k), some companies might cut back or discontinue other benefits.    

The participant’s retirement funds might now solely be in the ESOP. Though diversification options start at age 55, not all participants take advantage. Conversely, United Airlines famously defaulted on its pension in 2005. The Pension Guaranty Board limits benefits it will guarantee.  While many lower-paid and shorter-tenured employees were fine, higher-paid and longer-term employees saw pensions decline by as much as 50%.

The Downside for the Company

ESOPs cost money, and the largest investment is in the feasibility study and implementation. 

With a feasibility study, a company forecasts to see if it can provide for the ESOP’s operating costs as well as the eventual redemption of shares by participants. Often, several scenarios are run to see which works best, if any. Factors include borrowing from a bank, seller financing, tax consequences to both the owner and the company, as well as the expected turnover of employees. This latter factor considers normal turnover as well as retirement. The ages of the plan participants will have an important impact on when the funding must occur. The initial feasibility analyses determines important design features of the ESOP to help manage its cash flow needs.

Costs to consider here can be broken out between one-time set-up costs and ongoing costs.  Set-up costs are higher and include ERISA attorney fees for the feasibility, design and implementation, accountant consulting fees, third party administrator fees, valuation(s) for the feasibility study, and the cost of the external trustee.  The tax effect on the owners, too, is examined. 

Ongoing costs might include all the professionals cited in set-up costs. Often, an external trustee is used only for transactions. Attorney fees are incurred as needed. As workers age, the retirement obligation increases. A periodic study projecting this liability is typically recommended.

ESOPs are subject to audit by the IRS and the Department of Labor (DOL). There has been a lot of discussion in the press about DOL action against outside trustees in varying transactions. While this should provide additional reason to document how the prescribed steps are followed, maintaining a high degree of independence by the various advisors including the trustee will help ensure this is a non-event for your client.

The Downside for the Owner

The value in the transaction is not the strategic value an owner may attain on a sale to another company or even to management. An ESOP transaction is based on fair market value.  Simply stated, that reflects the value a third party will pay for the company under the premise that the buyer will continue to run the company in the same basic manner as the current owner.  In reality, this type of transaction occurs only in one-third of all transactions—the rest are strategic purchases where the buyer has a motive to purchase this company. This might include synergies of sales and operations, consolidation of overhead, or acquisition of key products or customers. In most cases, a strategic sale is priced higher than a third-party purchase. A fair market valuation might also reflect discounts for lack of control (or minority interest) and lack of marketability.

The deferral of capital gains taxes on the proceeds of a sale of the company under IRC  section1042 is currently available only to C Corporation shareholders.

If over 50% of the company moves into the ESOP, the owner, from an accounting viewpoint, probably does not have control. This issue of control is a highly debated topic in the valuation of an ESOP. There is a potential impact to the company as redemptions occur.

Other Considerations

Funding is an issue that might be less important for an ESOP—banks, which are not as ready to finance a management buyout, are ready to finance an ESOP acquisition, and ESOPs often receive preferential lending rates and other terms. A leveraged ESOP, though, has the downside of the debt being reflected on the company’s books. In only rare instances does the bank waive the company as a guarantor. The debt affects various liquidity ratios, which might place a company in violation of covenants associated with other debt. It might affect bid situations—for example, where company financial statements are presented with the bid proposal. These typically can be explained away or waived.

The payment by the company to the ESOP is tax deductible. If an ESOP is leveraged, the full loan payment, principal and interest, is deductible as well. Naturally, limits exist.

As with any employee benefit, there are regulations from regulatory agencies covering everything from limits of eligible compensation to dividends paid on employer securities.

In short, an ESOP can be a win-win for all parties in the right circumstances.

JenningsKevin Jennings, ABV, CVA, is the principal and senior valuation analyst with Jennings Business Valuation. He holds over 30 years’ experience in the field. Kevin has a bachelor’s degree in business administration in accounting and a master of science in accounting, both from Adelphi University. Kevin also belongs to various ESOP, trust and estate, and other associations on a local and national basis.


klinglerCarla Klingler is the senior pension consultant with Swerdlin & Company, a third-party administration firm. Carla holds over 30 years’ experience in the ESOP world and is a nationally renowned expert in the subject. Carla belongs to various ESOP, succession planning and other associations on a local and national basis.

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