Employee Stock Ownership Plans (ESOPs) are qualified retirement plans that reward employees with shares of stock of their employing company. This type of plan not only helps employees save for retirement, but also makes them shareholders and part-owners in the company. As an ESOP consultant, Aegis Fiduciary Services has witnessed these plans become increasingly popular particularly as baby boomer entrepreneurs and business owners begin thinking about retirement and how to best transition out of their business without closing the doors entirely.
However, just because ESOPs are becoming more common, does not mean they are suitable for all businesses. In this post, we take a look at the benefits and drawbacks of forming an ESOP and whether or not ESOP implementation for a business makes sense.
ESOPs and Their Effect on Businesses
According to the National Center for Employee Ownership (NCEO), there are approximately 6,500 ESOPs in the U.S., covering 14 million employees.
ESOPs are typically considered by mid-sized privately-owned businesses. They are a popular exit strategy for retiring owners who don’t want to shut down the business or sell it to a competitor or want the business to remain in the local community. ESOPs are also commonly implemented by business owners who want to “share the wealth” of the business’ success with their employees by rewarding them with company shares.
Employee Stock Ownership Plans are sponsored by the employing company and offered at no-cost to employees as part of their compensation and benefits package. They are recognized as qualified retirement plans by the IRS and the U.S. Department of Labor.
Benefits of ESOP Implementation For My Business
There are many benefits of ESOP implementation for a business. The benefits are both tangible and intangible.
- Employee Motivation. ESOPs motivate employees because they reward employee-participants for business success. Employees see real financial gains for their efforts that are over and above their paycheck. Knowing that their contributions support the company’s bottom line and, ultimately, their own pocketbook can change how employees view their job. Once they embrace the ownership mentality that comes with ESOP participation, employees become much more invested in the long-term success of a company. As a result, productivity improves, retention rates increase, and the company culture becomes more cooperative.
- Encourages Ownership Mentality. ESOP participants become part-owners of the ESOP-sponsoring company. This can be a new and different perspective for many employees. They are no longer working for the benefit of others, but for themselves. This change in perspective often leads to greater teamwork and problem-solving. Becoming an owner can boost employee morale and encourage long-term, strategic thinking about how to best move the business forward.
- Tax & Investment Benefits. Any ESOP consultant will tell you that ESOPs provide significant tax benefits to the current business owner. ESOPs provide owners with a way to sell their business stock without incurring capital gains taxes. S-Corps and C-Corps can form ESOPs, though they are more common with S-Corps. S-Corps that are 100% owned by an ESOP pay no income tax. C-Corps are able to deduct their ESOP contributions from their income taxes. Since the ESOP is a retirement account, participants don’t pay taxes on their accounts until the time of distribution or withdrawal.
- Builds a Legacy. ESOPs are very popular with family-owned businesses that want or need to transition ownership from the immediate family members. Under an ESOP, the current owner(s) can remain involved in the business as long as they like and in the manner in which they want to. The owner can remain involved in the day to day running of the business and continue to build the company. When the time comes to fully retire, they can rest easy knowing that the business will continue in the same vein, cementing their legacy in the community or industry.
- Takes Less Time to Implement. In general, forming an ESOP is quicker than selling the business. This is because an ESOP provides you with a ready buyer: your employees. There is no need to find a listing agent, market the business, and go through the listing and sales process to sell the business.
The Downside to ESOP Implementation For My Business
We’ve looked at some of the benefits offered by ESOPs, but what about the downside? ESOPs aren’t the right solution for every business. Here’s a look at some of the drawbacks to consider.
- They Can Get Expensive. ESOPs require the assistance of an ESOP consultant and other tax and legal professionals. They require ongoing management and administration. Many businesses hire outside trustees to do this for them. Leveraged ESOPs have a loan to repay and all ESOP businesses must be profitable enough to afford the contributions every year. Shares must be repurchased when an employee retires or leaves the company, which is another expense that must be planned for.
- Complicated to Implement. ESOPs can be complicated to set-up and manage. They are governed by ERISA and are subject to oversight by the Department of Labor and the IRS. It is critical to the success of the ESOP to meet all state and federal requirements. Mistakes or oversights can result in the plan being shut down. An ESOP is not something you can set-up and manage in-house. You will need help from ESOP consultants and ESOP fiduciaries.
- Requires Good Management. One of the most important pieces of ESOP success comes down to succession management. ESOPs that have a solid management team in place and a strong transition plan weather the change better than those that do not. A succession plan must be in place before setting up an ESOP, especially if it is to be a leveraged ESOP. Lenders will be wary of offering loans to businesses that don’t have a solid succession plan in place. The succession plan will also ease employee apprehension about the change, particularly if the business has a long history of being family-owned and operated.
- Will Not Yield a Significant Premium. An ESOP is unlikely to provide the departing business owner with the highest sale price. Outside strategic buyers or competitors will often pay a premium price in order to obtain the business. As a financial buyer, an ESOP cannot do this. By law they can only pay fair market value for the business shares.
- Not For Small Businesses. Given the set-up costs, ongoing administrative expenses, succession planning requirements, and contribution requirements, small businesses usually cannot afford to form an ESOP. For the smallest of businesses and start-ups, even the tax benefits cannot offset these expenses. In addition, ESOPs are only an option for C-Corps and S-Corps, not for partnerships or other professional corporations.
How An ESOP Consultant Can Help You Decide
Even after reading this, you may be wondering “Is an ESOP right for my business?” This is understandable because ESOP formation is complicated. It has far-reaching financial implications and it affects more than just the business owner. There are emotional considerations, management considerations, and practicalities that all complicate decision-making.
Meeting with an ESOP consultant is the best way forward. An ESOP consultant will be able to help you make sense of your exit options by examining your business financials and succession plan, discussing your personal and business goals for the transition, and taking in all of that information to advise you on the best option for your specific situation.
Meet with Aegis to Discuss ESOP Formation
Consult Aegis Fiduciary Services to get answers to your questions and others you haven’t considered. We have over 90 years of experience as ESOP fiduciaries and ESOP trustees and can help you determine whether or not an ESOP makes sense for your business. Contact the Aegis Team to schedule a consultation today.
Ready to find out more?
Get in touch with us to see how we can help your company transition to an ESOP or provide ongoing trustee services.
DISCLAIMER: The Articles displayed on this website do not constitute legal advice, nor do they substitute for the advice of qualified professionals. While the Articles displayed on this website are designed to provide information regarding the subject matter covered, we cannot guarantee the accuracy of any statements contained therein. If any legal advice or expert assistance is required, the services of qualified professionals should be sought.
Read More on the ESOP Blog
Looking for ESOP Trustee Services?
Fill out our online contact form to see if we are the right fit for your company.