What is an Employee Stock Ownership Plan (ESOP)?

An Employee Stock Ownership Plan (ESOP) is a type of employee benefit that provides employees with ownership in the company. In addition to benefiting employees with shares of stock, an ESOP can also be a viable exit strategy for a business owner considering retirement or looking for tax advantages.

 

How do ESOPS Work?

ESOP trusts, established by a company, allot shares to each employee, including rank-and-file workers. The business might make tax-deductible cash contributions to the trust to buy the owner's shares, contribute new shares to the trust on a tax-deductible basis, or arrange a bank loan for the ESOP to buy the owner's shares, with the company making deductible contributions to repay the loan, according to the National Center for Employee Ownership (NCEO).

Depending on how it's structured, an ESOP offers flexibility and a variety of potential benefits, enabling the owner to:

• Retain control for years
• Sell at an attractive valuation
• Hold on to good managers who will eventually take over the company
• Enjoy significant tax advantages, in some circumstances including deferred capital gains on the sale.

Cashing Out and Transitioning From ESOP

Owning stock in an ESOP company isn’t quite the same as owning shares in the stock market because employees aren’t able to simply sell their shares and cash out whenever they want. In most cases, employees are only able to cash out their ESOP shares if they terminate employment, retire, or become disabled. Even in those cases, you may have to reach a certain age, such as 59 ½, to take a distribution from your ESOP.

Your options for selling your ESOP shares will depend on the company and the ESOP structure. Some companies will purchase the shares back and provide you with cash, while others will provide you with stock that you may resell to the company within 60 days. Some employers will provide a lump sum payment for ESOP shares, while others make payments over a period of one to five years.

Cashing out of your ESOP will result in tax implications. Typically, you’ll be required to pay taxes on the distribution at your ordinary income tax rate. If you are younger than 59 ½, you may have to pay an early withdrawal penalty unless you roll the distribution into a tax-advantaged retirement account such as an 401(k) or traditional IRA.

 

Do Employees Have to Pay for ESOPs?

No, employees do not typically have to pay to participate in an ESOP. The plans are funded by the company rather than through employee contributions. Each participating employee receives company shares in their ESOP accounts, allocated based on factors like tenure and salary.

What Happens to ESOP If an Employee Leaves?

If you quit your job, you will still own your vested ESOP shares. If you have some ESOP shares that are not fully vested, you will typically lose those shares and any associated value. Each company has its own vesting schedule, so you will need to review your ESOP requirements to determine whether your shares are fully vested or not. In some companies, vesting happens immediately, while in others, vesting happens gradually over time or after a certain number of years.

 

What are the Advantages of ESOP?

In addition to providing a valuable benefit for employees, ESOPs also offer advantages for business owners. An exiting business owner typically can secure an attractive valuation for his or her business through an ESOP, which the IRS classifies as a qualified defined-contribution plan.

Through an ESOP, companies with revenue under $100 million can typically land a price of 6 times EBITDA (earnings-before-interest-taxes-depreciation-and-amortization), while those generating $100 million and higher may be able to obtain 10x EBITDA.

Companies typically provide employees with shares of the company without any upfront costs, and hold the shares in a trust until the employee retires or leaves the company. Usually, companies tie distributions from the ESOP to vesting based on a dedicated vesting schedule. For example, a company might earn an increasing proportion of shares for each year of service.

When vested ESOP employees retire or leave the firm, the company purchases the workers' stock for cash, which can be paid to the employee in a lump sum or equal periodic payments, depending on the plan.

After purchasing the shares and paying the employee, the company can redistribute the shares or place them in the business's treasury. Keeping shares in the business can ultimately leave key employees in control once the owner retires. However, a company could take a financial hit by continuing to recycle and repurchase former employees' shares.

An S Corporation using an ESOP can also enjoy the added benefit of operating tax-free because income on the share of the business owned by the trust is exempt from taxes.

 

How to Start an ESOP?

For business owners who are considering an ESOP as an exit strategy, it’s a good idea to start several years before your planned retirement. Many ESOPs operate five to 10 years with the owner still in place before retirement.

To start an ESOP, most companies will need to follow a number of steps, including:

• Undertake a feasibility study. Consider how much cash the company will need to provide to start and maintain the ESOP, handle repurchase obligations when employees leave, and whether those costs are feasible for the company.
• Conduct a valuation of the business. It’s a good idea to determine the current value of the business before pursuing an ESOP. If the valuation is higher than expected, you may want to sell, and if the valuation is lower, you need to decide whether investing in an ESOP is worth it to you.
• Submit a plan to the IRS. Work with an attorney to develop an ESOP plan, which will have to be approved by the IRS. It may take a few months to receive a determination, and if the IRS rules unfavorably, you may just have to make some changes to the plan.
• Obtain funding for the ESOP. In many cases, the company funds its own ESOP by making ongoing contributions. The ESOP can also borrow money from a bank or other lender, or employees can make contributions to the plan.
• Create an operations model. Select a trustee to oversee the ESOP and appoint employees to serve on an ESOP committee. Establish processes and procedures for initiating employee participation and maintaining plan operations.

 

Seek Expert Advice in Determining Your Exit Strategy

If you're considering an ESOP for your business, it's important to take into account the complexity and time involved in planning and executing the plan successfully.

Hire a team of advisors: a CPA; a financial planner; an attorney with expertise in business, tax and estate planning; an ESOP consultant; a banker; an independent business valuation expert; an insurance agent; key employees — to help you consider all factors and options and design a successful plan.

While an ESOP offers many advantages, it might not be right for a company that doesn't have valued, long-term employees and management in place. ESOPs also generally make sense for businesses with at least $10 million in annual revenue. Companies also need to weigh the effect of plan fees against benefits.

City National Bank's wealth planners can help you develop an exit strategy for your business that will preserve your legacy and provide you with retirement funds.