ESOPs put ownership in the hands of employees, giving them a higher stake in company success.
These retirement plans are not new, but the benefits are still not commonly understood.
ESOPs appeal to business owners for succession planning and to employers for inclusion in rewards packages.
An ESOP is a unique type of qualified retirement plan that invests primarily in employer stock, putting ownership in the hands of employees and giving them a higher stake in the company’s success. Similar to other qualified retirement plans, such as 401(k) plans, employers make contributions to the ESOP, accounts are maintained for individual employees, and employees are generally taxed on the amounts when they receive distributions from their accounts.
With the plan’s investment in employer stock, the employees’ accounts can appreciate as the company grows. In addition to providing employees with an ownership stake in the company that grows until their retirement, an ESOP also gives current shareholders a market in which they can sell their stock.
The first step is for the company to form and adopt the plan. As with other qualified retirement plans, many considerations go into the initial plan design, including eligibility requirements, vesting provisions and distribution timing.
After initial setup, the ESOP purchases a portion of the company’s stock. The portion varies—some ESOPs own 20% of the company’s equity, for example, while others may own 100%. The company may contribute cash or shares to the plan without using any financing. However, typically the stock purchase occurs through a leveraged structure in which the company loans the purchase amount to the ESOP and holds the shares as collateral on the ESOP loan. The ESOP then releases shares to participant accounts over time as the loan is repaid using cash contributions from the employer to the ESOP. To assist with the transaction, the company may also obtain financing from a bank to have the cash available to fund the ESOP’s share purchase.
An ESOP provides employees, the company and selling shareholders with unique opportunities—and all three parties should be considered to ensure the plan is a good fit. Do the employee demographics make an ESOP financially feasible for the company? Are the unique benefits available to selling shareholders desirable to the current owners? Can the company afford to make the required contributions and purchase employees’ stock when they separate from service?
Although ESOPs can be very attractive, their implementation and annual administration involve costs. Thus, a company should ensure an ESOP’s sustainability before implementation. The business should have a history of profitability and the potential for strong growth to ensure that it can make contributions to the ESOP and fund distributions to participants leaving the plan, and that the benefits to employees will increase in value. In addition, the company should have a qualified management team to carry out the business, support employee ownership and handle ESOP compliance matters effectively. The company culture should encourage employee involvement and foster communication and participation.
In addition, certain characteristics of the employee base—such as the number of employees, payroll level compared to company value, turnover rates and the average age of employees—contribute to the determination of a company’s suitability for an ESOP. Engaging qualified professionals to analyze these factors helps ensure that obligations related to contributions to the plan and distributions from the plan can be met within the company’s cash flow and desired employee benefit levels.
Like other qualified retirement plans, an ESOP has certain annual reporting obligations—including those related to audit, tax, valuation and administration—typically handled by outside advisors. In addition, to properly manage cash flow, the company must plan for distributions, diversification and employee benefit levels. The plan administrator and the company’s advisors can manage these issues.
With this basic, ongoing maintenance, an ESOP can provide the tax savings and added employee incentives to position the company for growth and prosperity.
For owners interested in selling their stock, a major consideration is what type of buyer is best, based on the shareholders’ goals. An advantage of an ESOP is that it can create a more readily available market for the stock in a closely held company, where the number of potential buyers who are interested, able and align with shareholders’ desires for the future of the company may be limited.
Owners may also wish to avoid disrupting the current workforce through an ownership transfer. Transferring ownership to the employees may reduce the possibility that the company’s operations, management or overall dynamics will change.
Another valuable potential benefit is a unique tax deferral option, described below.
If the company is a C corporation, the seller can potentially defer tax on any gain on the stock sale if reinvesting the proceeds into qualifying replacement securities. This favorable tax deferral provision is similar to a section 1031 like-kind exchange, but it applies specifically to selling C corporation stock to an ESOP that owns at least 30% of the company stock after the sale.
If this tax deferral option is elected, the seller and certain relatives cannot participate in the ESOP after the sale. In general, this option defers the tax consequences of the sale. However, under the current estate tax rules, if the seller dies before selling the replacement securities, the beneficiaries will receive a step-up in the stock basis, and the income tax on any gain realized at the time of sale to the ESOP would essentially never be paid. Currently, this tax deferral option is unavailable if the company is an S corporation on the date of the sale; beginning in 2028, up to 10% of the gain on S corporation stock may qualify for tax deferral.
Without a tax deferral election, a selling shareholder receives capital gains treatment on the stock sale.
Because an ESOP is a qualified retirement plan, participants receive distributions in the same manner as they would from other retirement accounts. Ultimately, the ESOP plan provisions dictate how and when distributions occur, but the main events usually leading to distributions include death, disability, termination of employment and retirement. Distributions may be made in a lump sum or installments and may commence within certain time frames of these events.
Participants are generally taxed at the time of distribution. But they can elect to roll over the distribution into another qualified plan, which defers taxation until a distribution is received from the rollover plan. Since a participant’s account consists mainly of employer stock, the plan will either distribute the cash value of that stock at the time of distribution or, if stock is distributed, include a put option whereby the employee can immediately sell the stock to either the ESOP or the employer. This policy exists so that employees are not left holding employer stock that may not be easily converted into cash in an outside market.
Most individuals are more familiar with 401(k) plans, which generally allow employees to choose from an array of diversified investment options. Although the assets of the ESOP are not diversified, employees at ESOP companies often end up with larger retirement account balances than those at non-ESOP companies because the ESOP is usually offered in addition to other retirement plans.
U.S. Department of Labor research also shows that ESOPs have higher rates of return and are less volatile than 401(k) plans. Moreover, ESOPs generally cover more employees because participation is automatic, and employees do not typically have to elect into the plan. An additional benefit is that diversification rules require the ESOP to provide participants who are age 55 or older and have been in the plan for at least 10 years the option to diversify a portion of their accounts.
When an owner sells to an ESOP, the company has a new retirement plan, which requires regular and continuous contributions. Those contributions are tax-deductible employee benefit expenses.
Most ESOPs are structured so that the company obtains financing from an outside creditor or seller when stock is purchased. The company then loans the cash to the ESOP to purchase stock from the company or any selling shareholders. The payments the ESOP makes on that debt become tax deductible to the company because the company funds the ESOP’s debt payments with its regular and continuous contributions to the ESOP.
In addition, a C corporation may receive a tax deduction for dividends paid to an ESOP. An S corporation can receive even more favorable tax treatment because the ESOP is not taxed on its share of S corporation earnings. And since the S corporation is generally not taxed at the entity level, company earnings allocable to ESOP ownership escape current taxation.
Along with providing tax incentives, an ESOP helps create a culture that promotes productivity, responsibility, loyalty and employee participation.
Another advantage of having employees’ retirement benefits invested in employer stock is the potential for increased employee engagement. An ESOP may incentivize strong employee performance, increase productivity and loyalty, and serve as a recruiting tool to attract new employees. Individuals who place high importance on environmental, social and governance concerns may be particularly drawn to an ESOP-owned company.
The benefits of an ESOP do not come without costs to the company—but in most cases, the benefits far outweigh the costs. Costs incurred during the initial year of the ESOP include those associated with an independent appraisal to support the stock price; accounting and legal services related to advising on ESOP effects and terms; preparing and effecting documents; financing; and operating and administering the plan.
The initial costs depend on the company size, industry, availability of information for valuation purposes and financing structure, among other factors. After the initial year, ongoing annual costs include fees for an annual valuation, audit fees if the plan has 100 or more participants, administration costs (which usually include a flat fee plus a charge per participant) and tax return preparation fees.
Generally, having an ESOP in place should not affect the company’s day-to-day business. One area that changes slightly, however, is corporate governance. The ESOP trustee and non-ESOP shareholders elect the board of directors. Maximizing shareholder value means considering employee interests since employees are now shareholders. Often the board of directors appoints the ESOP trustee, who represents the employees. Thus, governance can be somewhat circular, and the company should be careful to follow fiduciary standards.
In addition, as explained previously, an ESOP can foster a culture of employee involvement, responsibility and loyalty. Thus, while day-to-day tasks should not change, a more team-oriented culture may evolve, and productivity may increase. When combined with the tax benefits of an ESOP, these factors often lead to faster growth for ESOP-owned companies.
Through every stage of an ESOP—including initial consideration, the transaction itself and post-transaction operations—an experienced ESOP advisor can:
RSM’s ESOP advisory professionals can help you optimize tax benefits, consider ESOP-specific operational requirements, meet your company’s desired goals and comply with complex laws and regulations. Reach out to begin a conversation.
Case study
Ten years ago, a large family-owned manufacturing company made a pivotal decision to establish an ESOP. At the time, the company employed approximately 600 people. The family chose the ESOP route to preserve control of the business, avoid selling to an outside party and align with the company’s strong, people-first culture.
The family sold the entire business to the ESOP, committing fully to a transition that prioritized both employee ownership and long-term stability. RSM played a key role in guiding the family and management through the complex process. This included advising on the transaction structure, addressing tax implications and managing key business considerations to ensure a smooth implementation.
The results speak for themselves. A decade later, the company has grown to nearly 1,000 employees and boasts an enterprise value of $300 million. By transitioning to an ESOP, the family not only safeguarded the company’s legacy but also empowered its employees to share in the success of the business, further strengthening the culture and fostering long-term growth.
