An Employee Stock Ownership Plan, or ESOP, is a qualified retirement program in which employees receive shares of the business rather than stock. ESOPs are said to be “qualified” because they qualify for federal income tax deferral until the stock is turned into cash at retirement. ESOPs are in most respects similar to 401(k) plans except that, instead of cash, the company providing the ESOP “pays in” its own stock. But, as in 401(k) plans, all full time employees must be eligible provided that they meet certain age and service requirements. Unlike a 401(k) plan, contributions to an ESOP by the employer do not become the property of the employee until after specified vesting periods are satisfied. Under both programs, employees receive monetary benefits on retirement or in the event of death or disability. The chief difference between ESOPs and 401(k)s is that, in the latter, the funds paid in are invested in a diversified portfolio; in the ESOP they hold only the company’s own stock. The advantages and risks of ESOPs derive from this difference.
An ESOP offers employers two advantages. First, the company gets significant tax breaks. It can, for example, borrow money through the ESOP for expansion or other purposes and then deduct both the repayment and interest when it pays back the loan. In the case of ordinary loans, only interest payments are tax deductible. In addition, the business owner who sells his or her stock holdings to the ESOP can often defer or even avoid capital-gains taxes associated with the sale of the business.
In this way, ESOPs have become an important tool in succession planning for business owners preparing for retirement.
A less tangible advantage many employers experience when forming an ESOP is an increase in employee loyalty and productivity. Employees become owners of the company; having a stake in it, their relationship to the company changes. An ESOP therefore provides a financial incentive—but also something that goes beyond future compensation. Small businesses are at a disadvantage over against large company because they provide less compensation and fewer benefits on average. An ESOP therefore helps small businesses recruit and retain employees by offering ownership benefits.
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Growth Of Esops
The first ESOP was created in 1957, but the idea did not attract much attention until 1974 when plan details were laid out in the Employee Retirement Income Security Act (ERISA). The number of businesses sponsoring ESOPs expanded steadily during the 1980s as changes in the tax code made plans more attractive for business owners. Although the popularity of ESOPs declined during the recession of the early 1990s, the programs have expanded since. According to the National Center for Employee Ownership, the number of companies with ESOPs grew from 9,000 in 1990 to 10,000 in 1997.
By 2004, there were 11,500 ESOPs with 10 million participants. The ESOPs had $500 billion in assets.
In order to establish an ESOP, a company must have been in business and shown a profit for at least three years. One of the main factors limiting the growth of ESOPs is that such plans are relatively complicated and require strict reporting; thus can be quite expensive to establish and administer. Steve Miller, writing for Top Producer, provided estimates of $35,000 to $50,000 for establishing ESOPs; annual fees for stock appraisals and record keeping are between $5,000 and $10,000.
Appraisals are necessary in the case of closely held corporations that are not publicly traded in order to satisfy federal law. These costs are substantial—but they are tax deductible.
Employers can choose between two main types of ESOPs, loosely known as basic ESOPs and leveraged ESOPs. They differ in the ways in which the ESOP obtains the company’s stock. In a basic ESOP, the employer simply contributes securities or cash to the plan every year—like an ordinary profit-sharing plan—so that the ESOP can purchase stock. Contributions are taxdeductible up to a maximum equivalent to 15 percent of payroll. In contrast, leveraged ESOPs obtain bank loans to purchase the company’s stock. The employer can then use the proceeds of the stock purchase to expand the business or to fund the business owner’s retirement nest egg. The business can repay the loans through contributions to the ESOP that are tax-deductible up to a maximum of 25 percent of payroll.
An ESOP can also be a useful tool in facilitating the buying and selling of small businesses. For example, a business owner nearing retirement age can sell his or her stake in the company to the ESOP in order to gain tax advantages and provide for the continuation of the business. Some experts claim that transferring ownership to the employees in this way is preferable to third-party sales. Third-party sales have negative tax implications if successful. But buyers may be difficult to find; and after the transaction, collecting installment payments may turn out to be difficult or costly. Using the ESOP, more certain results are possible. The ESOP can borrow money to buy out the owner’s stake in the company. If, after the stock purchase, the ESOP holds more than 30 percent of the company’s shares, the owner can defer capital-gains taxes by investing the proceeds in a Qualified Replacement Property (QRP). QRPs can include stocks, bonds, and certain retirement accounts. The income stream generated by the QRP can help provide the business owner with income during retirement.
ESOPs can also prove helpful to those interested in buying a small business. Many individuals and companies choose to raise capital to finance such a purchase by selling nonvoting stock in the business to its employees.
This strategy allows the purchaser to retain the voting shares in order to maintain control of the business. At one time, banks favored this sort of purchase arrangement because they were entitled to deduct 50 percent of the interest payments as long as the ESOP loan was used to purchase a majority stake in the company. However, this tax incentive for banks was eliminated with the passage of the Small Business Jobs Protection Act of 1996.
In addition to the various advantages that ESOPs can provide to business owners, sellers, and buyers, they also offer benefits to employees. Like other types of retirement plans, the employer’s contributions to an ESOP on behalf of employees are allowed to grow taxfree until the funds are distributed upon an employee’s retirement. At the time an employee retires or leaves the company, he or she simply sells the stock back to the company. The proceeds of the stock sale can then be rolled over into another qualified retirement plan, e.g., an Individual Retirement Account (IRA) or a plan sponsored by another employer. Another provision of ESOPs gives participants—upon reaching the age of 55 and putting in at least ten years of service—the option of diversifying their ESOP investment away from company stock and toward more traditional investments.
The financial rewards associated with ESOPs can be particularly impressive for long-term employees who have participated in the growth of a company. Of course, employees encounter some risks with ESOPs, too: their retirement funds are invested in the stock of one small company. In fact, an ESOP may become worthless if the sponsoring company goes bankrupt. But history has shown that this scenario is unlikely to occur: only 1 percent of ESOP firms have gone under financially in last 20 years.
Who Should Establish An Esop
Although 1996 legislation opened the door for S corporations to establish ESOPs, the plans continue to be much more attractive for C corporations. In general, ESOPs are likely to prove too costly for very small companies, those with high employee turnover, or those that rely heavily on contract workers. ESOPs might also be problematic for businesses that have uncertain cash flow; companies are contractually obligated to repurchase stock from employees when they retire or leave the company. Finally, ESOPs are most appropriate for companies that are committed to allowing employees to participate in the management of the business. Otherwise, an ESOP might tend to create resentment among employees who become part-owners of the company and then are not treated in accordance with their status.