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How to Establish an ESOP
What is a Leveraged ESOP?
Use of ESOPs
Tax Advantages of ESOPs

How to Establish an ESOP

How to Establish an ESOP

A company interested in establishing an Employee Stock Ownership Plan (ESOP) has a wide range of options in tailoring a plan that is best suited to its particular needs and goals. A large, publicly traded company, for example, would handle the creation of its ESOP somewhat differently than would a smaller firm. Presented below, therefore, is only a basic guideline summarizing the steps a company might take in designing its ESOP and bringing it into being.

Exploring The ESOP Concept

The first step in the process of establishing an ESOP is to develop an idea of the type of plan that will best serve the company's interests. Companies have created ESOPs as an employee retirement plan, for purposes of business continuity, financing, enhanced employee motivation or as a combination. The ESOP Association provides a wide array of information and other assistance to companies interested in exploring the potential benefits of an ESOP. Contact The ESOP Association to inquire regarding affiliate membership.

Designing The Specifics

Once you have a general picture of the kind of ESOP you want, a qualified consultant will work with you to design the specifics of the ESOP. The actual feasibility of an ESOP needs to be established. Custom-tailored answers to the many questions need to be answered. Who will participate in the plan? How will stock be allocated to participants? What vesting schedule will be adopted and how will distributions of ESOP accounts be handled? How will voting rights be handled? The ESOP Association provides the names of such consultants throughout the country. The consultant will work to integrate the ESOP goals with applicable laws and regulations and will conduct a financial analysis to assure that any financial commitments posed by the ESOP will not exceed the ability to the firm to meet such obligations. He or she may also offer possibilities previously overlooked. The consultant may also arrange to bring in other professionals, such as an appraiser, or a lending institution as appropriate.

In the case of a privately held company, the feasibility and design phase of the process is not usually complete until three additional points have been addressed. First, the firm's stock must be valued by an independent appraiser before shares are put into the ESOP. Initially, a careful estimate will be prepared for use as a working figure in the feasibility and design process. This initial appraisal will likely take several weeks or longer, since a significant amount of business data must be collected and analyzed. Only when the design process is completed and ready for implementation will a final and formal valuation report be prepared. For more information on valuing ESOP stock, visit the Publications and Products section for Issue Brief #8 “The Valuation of ESOP Stock,” publications “An Introduction to ESOP Valuations,” “Valuing ESOP Shares,” and the “Report on Valuation Considerations for leveraged ESOPs.”

Second, the ESOP's effect on existing stockholders should be estimated. Stockholders will want to know how the ESOP will affect the value of their stock and the company's financial condition. Often an ESOP will cause a dilution of their equity interest in the corporation.

Finally, while not a requirement for establishing an ESOP, a plan for meeting the private closely held company's obligations to repurchase the stock of departing employees should be projected. This "repurchase obligation" arises from the fact that in privately held companies, ESOP participants have a put option when leaving the company. The repurchase obligation and its growth over time may be affected by factors like the size of the annual ESOP contributions, the change in the value of shares between the dates of contribution and repurchase, the vesting and distribution provisions of the ESOP, employee turnover and, for shares contributed after December 31, 1986, the choices eligible employees make about their diversification option.

Companies may plan for and meet their ESOP repurchase obligation in a variety of ways, including making substantial cash contributions on an annual basis, and buying insurance to cover the plan's obligations. If the likely growth of repurchase obligation over time is projected at the outset, however, the company is in the best possible position to plan for it and design the ESOP accordingly.

Putting The ESOP In Place

When the process of analyzing and designing the ESOP is complete, the company will typically have an attorney prepare a formal plan document which will set forth the specific terms and features of the ESOP. An appraiser will then prepare a finished and formal evaluation report, based on data preferably no more than 60 days old at the date the ESOP is created.

The plan document should include language addressing the plan's purpose and operation, eligibility requirements, participation requirements, company contributions, investment of plan assets, account allocation formulas, vesting and forfeitures, voting rights and fiduciary responsibilities, distribution rules and put options, employee disclosures, and provisions for plan amendments. Depending on the particular circumstances of the establishment of the ESOP, it may be prudent to address any future contingencies in the plan document.

Other key decisions are who will serve as the ESOP's trustee and who will assume the functions of administering the ESOP? The stock (as well as any other assets) held by the ESOP must actually be held in the name of the trustee, who usually has fiduciary responsibility for the plan's assets. Increasingly, plan sponsors are turning to professional trustees, such as a bank or trust company, although companies sponsoring an ESOP can and do handle this role in-house. The job of ESOP administration is likewise a function which may be given to a professional administration firm or handled by the sponsor. The administrator is responsible for maintaining all the individual records of the plan in order to keep track of exactly who are the current participants in the plan, what percent is each participant vested, what is the content and value of each participant's account, etc.

In the case of leveraged ESOPs (an ESOP which used borrowed funds to acquire employer securities), arrangements must be made for securing the financing needed to complete the transaction. Banks, savings and loans, investment banking firms, mutual funds, and insurance companies in the business of lending money may all qualify as ESOP lenders. Lending institutions are becoming increasingly familiar with how ESOP loans are structured. If you local lending institution is unable to provide the necessary funding, a list of interested lenders is available from The ESOP Association.

The company must formally adopt the plan and trust documents which establish the ESOP and its attendant trust. Also, the company usually submits a copy of these documents to the Internal Revenue Service with an application for confirmation (called "determination") of the plan's tax-qualified status (Form 5300). The plan must be a qualified ESOP under sections 401 (a) and 4975 (e)(7) of the Internal Revenue Code in order to be eligible for the various tax benefits associated with ESOPs. It is not normally necessary, however, to wait for a letter of determination from the IRS to begin the plan. If there is nothing unusual in the plan's design, any required changes will almost certainly be small ones, which can be made after the plan has begun operation.

A company must adopt an ESOP by the end of its fiscal year to claim a deduction for its contribution for that year. Contributions and leveraging for a given year, however, may occur up until the company files its corporate tax return, including extensions.

Conclusion

The process of setting up an ESOP seems complicated, but that should not discourage interested firms from investigating employee ownership. In fact, in many ways selling or contributing stock to an ESOP is less complicated and costly than selling stock to an outside third party.  The process is understandable and manageable, and the many benefits which flow from ESOPs, such as increased employee motivation, a market for existing shareholders shares, and tax and financial advantages, are substantial.

What is a Leveraged ESOP?

In a leveraged ESOP, the ESOP or its corporate sponsor borrows money from a bank or other qualified lender. The company usually gives the lender a guarantee that it will make contributions to the trust which enable the trust to amortize the loan on schedule; or, if the lender prefers, the company may borrow directly and make a loan back to the ESOP. If the leveraging is meant to provide new capital for expansion or capital improvements, the company will use the cash to buy new shares of stock in the company. If the leveraging is being used to buy out the stock of a retiring owner, the ESOP will acquire those existing shares. If the leveraging is being used to divest a division the ESOP will buy the shares of a newly created shell company, which will in turn purchase the division and its assets. ESOP financing can also be used to make acquisitions, buy back publicly-traded stock, or for any other corporate purpose.

Two tax incentives make borrowing through an ESOP extremely attractive to companies which might otherwise never consider financing their employees acquisition of stock. First, since ESOP contributions are tax deductible, a corporation which repays an ESOP loan in effect gets to deduct principal as well as interest from taxes. This can cut the cost of financing to the company significantly, by reducing the number of pre-tax dollars needed to repay the principal by as much as 34%, depending on the company's tax bracket. Two, dividends paid on ESOP stock passed through to employees or used to repay the ESOP loan are tax deductible if the ESOP sponsor operates as a C corporation.  If the ESOP sponsor is an S corporation, dividends may be used to pay the ESOP debt, but there is no tax deduction as the S pays no corporate income tax. This provision of federal tax law may increase the amount of cash available to a company compared to one utilizing conventional financing.

Use of ESOPs

The two most common uses of ESOPs are to buy the stock of a retiring owner in a closely held company, and as an extra employee benefit or incentive plan. These two uses probably account for over two thirds of all the ESOPs now in existence. The proportion of ESOPs created to buy out a retiring owner can be expected to increase with time, because tax provisions encourage retiring owners to sell to an ESOP. Other companies have used ESOPs as a technique of corporate finance for a variety of purposes--to finance expansion, make an acquisition, spin off a division, take a company private, etc. In a small number of cases—about 2%—ESOPs have been used to buy out a failing firm that would otherwise close.

Buying The Stock Of A Retiring Owner

Many closely held companies have no plans, or incomplete plans, for business continuity after the departure of retirement of the founder or major shareholder. If the company repurchases a retiring or departing owner's shares, the departing owner sells his or her stock to another company, the proceeds will be taxed as ordinary income, or as capital gains if certain requirements are met, and, finding a buyer is not always easy even for a profitable closely-held company. Even if possible, it is not always desirable; furthermore in a family business, a retiring owner may face an unpleasant choice between selling to a competitor or conglomerate, or liquidating.

An ESOP can provide a market for the equity of a retiring owner—or any interested major shareholder—of a closely held company, and provide a benefit and job security for employees in the process. Retiring owners of closely held companies incur no taxable gain on a sale of stock to an ESOP, provided that the ESOP owns at least 30% of the company immediately after the sale (sales by two or more stockholders may be counted in this 30% if these sales are part of an integrated transaction), and that the sale's proceeds are reinvested in qualified securities within a fifteen month period beginning 3 months before the date of the sale. This tax-deferred rollover is a most tax favored way for an owner of a closely held company to sell his or her stock.

Employee Benefit Or Incentive

Most ESOP companies had the desire to set up an employee benefit or incentive as one reason for starting their plan, but for many companies that's the only reason. Some companies hope that by making employees owners they will increase their dedication to the firm, improve work effort, reduce turnover, and generally bring a more harmonious atmosphere to the company. Research has shown that giving workers a significant stake in their companies can improve employees' attitudes towards their companies, and that these improved attitudes towards their companies can translate into bottom line improvements. Other companies want to set up some kind of benefit plan, and find that an ESOP is the best choice.

The Employee Ownership Foundation released convincing evidence in February 2012 from the most prestigious social survey in the U.S., the General Social Survey (GSS), that showed employees in the U.S. who had employee stock ownership were four times less likely to be laid off during the Great Recession than employees without employee stock ownership.

Specifically, the 2010 GSS, funded primarily by the National Science Foundation and conducted by the National Opinion Research Center at the University of Chicago, found that 3% of employees with employee stock ownership, which include the ESOP model and other forms of employee ownership, were laid off in 2009-2010 compared to a 12% rate for employees without employee stock ownership.

In addition, the 2010 GSS data indicated that 13% of the employees with employee stock ownership intended to leave their companies in the coming months whereas the rate was 24% for employees without employee stock ownership. This indicates significantly lower expected turnover for workers with employee stock ownership.

Additionally, the survey found that employee ownership rates remained stable since 2006 with 17.4% of individuals reporting they owned company stock. About 19 million U.S. citizens own stock in the companies in which they work.

The Employee Ownership Foundation provided significant funding for the supplemental series of questions on shared capitalism in the survey. Shared capitalism is defined as broad-based employee, current or deferred, stock compensation programs, such as ESOPs (employee stock ownership plans), stock purchases, stock options, gain sharing, profit sharing, and bonus programs. The shared capitalism series of questions were developed and analyzed by well-known employee ownership researchers, Professor Joseph Blasi and Professor Douglas Kruse (School of Management and Labor Relations at Rutgers University) who submitted an application for their inclusion in the GSS. The researchers are continuing to analyze these and other related data from the Survey to shed light on the role of employee stock ownership in the U.S. economy.

In 2009, the Employee Ownership Foundation, conducting its 18th Annual Economic Performance Survey, found that a very high percentage of companies, 88.2%, declared that creating employee ownership through an ESOP (employee stockownership plan) was “a good decision that has helped the company.” In addition, the EPS asked companies to indicate their performance in 2008, relative to 2007. Approximately 50.4% of respondents indicated a better performance in 2008 than 2007, 9.4% indicated a nearly identical performance, and 39.7% indicated a worse performance. Around 57.9% indicated that revenue increased while 42.1% indicated revenue did not increase. In terms of profitability, 50.4% indicated that profitability did increase and 49.6% indicated that profitability did not increase in 2008.  Finally, in 2009, 88.5% of companies responding to the survey indicated they outperformed the three major stock indices in 2008 including the Dow Jones Industrial Average, the NASDAQ Composite, and the S&P 500. This survey was conducted in the summer of 2009 among corporate members of The ESOP Association.  The results are based on 429 responses.

The most comprehensive and significant study to date of ESOP performance in closely held companies was conducted by Dr. Joseph R. Blasi and Dr. Douglas L. Kruse, professors at the School of Management and Labor Relations at Rutgers University, and funded in part by the Employee Ownership Foundation.  The study, which paired 1,100 ESOP companies with 1,100 comparable non-ESOP companies and followed the businesses for over a decade, reported overwhelmingly positive and remarkable results indicating that ESOPs appear to increase sales, employment, and sales/employee by about 2.3% to 2.4% over what would have been anticipated, absent an ESOP.  In addition, Drs. Blasi and Kruse examined whether ESOP companies stayed in business longer than non-ESOP companies and found that 77.9% of the ESOP companies followed as part of the survey survived as compared to 62.3% of the comparable non-ESOP companies.  According to Drs. Blasi and Kruse, ESOP companies are also more likely to continue operating as independent companies over the course of several years.  Also, it is substantially more probable that ESOP companies have other retirement-oriented benefit plans than comparable non-ESOP companies, such as defined benefit plans, 401(k) plans, and profit sharing plans.

Tax Advantages of ESOPs: C and S

Introduction

In order to broaden the ownership of capital to provide employees with a stake in the ownership of their employing corporation and to provide a unique means of financing to corporations, Congress has granted a number of specific incentives meant to promote increased use of the ESOP concept. This is especially true for leveraged ESOPs, which through the use of borrowed funds provide a more accelerated transfer of stock to employees. These ESOP incentives provide numerous advantages to the sponsoring employer and can significantly improve corporate financial transactions.  The leadership of a corporation setting up an ESOP will need to understand the different tax advantages available to a C corporation compared to an S corporation and vice versa.

Deductibility of ESOP Contributions

As with all tax-qualified employee benefit plans, contributions to ESOPs are tax deductible to the sponsoring corporation up to certain limits. These contributions can be either in cash (which is then used by the ESOP to buy employer securities) or directly in the form of employer securities. Where employer securities are contributed directly, the employer may take a deduction for the full value of the stock contributed. By doing so, the employer actually increases its cash profits by the value of the taxes saved through the deduction.

The deductibility of contributions to an ESOP becomes even more attractive in the case of a leveraged ESOP. Under this arrangement, an ESOP takes out a cash loan from a bank or other lender, with the borrowed funds being paid to the sponsoring employer in exchange for employer securities. Since contributions to a tax-qualified employee benefit plan are tax deductible, the employer may thereafter deduct contributions to the ESOP which are used to repay not only the interest on the loan, but principal as well. This makes the ESOP an attractive form of debt financing for the employer from a cash flow perspective. Each year, the company can deduct contributions of amounts up to 25% of covered payroll, plus any dividends on ESOP stock (see "Deductibility of Dividends" below) if a C corporation which are used to repay the loan. Further, any contributed amounts used to repay the interest on the loan are deductible without any limit at all.  [S corporations should check with ESOP counsel before using the interest as deductible.

ESOP Rollover

An additional ESOP incentive allows a shareholder, or shareholders, of a closely held C corporation to sell stock in the company to the firm's ESOP and defer federal income taxes on the gain from the sale. In order to qualify for this "rollover," the ESOP must own at least 30% of the company's stock immediately after the sale, and the seller(s) must reinvest the proceeds from the sale in the securities of domestic operating corporations within fifteen months, either three months before, or twelve months after the sale. The seller, certain relatives of the seller, and 25% shareholders in the company are prohibited from receiving allocations of stock acquired by the ESOP trough a rollover. Generally, the ESOP may not sell the stock acquired through a rollover transaction for three years.

The ESOP rollover provides a substantial tax advantage that might otherwise be unavailable to current or retiring owners. Normally, a direct shareholder's options would be to sell shares back to the company, if such a transaction is feasible, or to sell out to another company, either for cash or for a block of shares in the other company. Selling to an ESOP, on the other hand, allows the seller to exchange interest in the company for a safely diversified portfolio of securities—or the stock of a single new company—without paying any taxes on the transaction. The seller's tax basis in the employer stock which were sold will be carried over to the replacement property. If the replacement property is held until death, however, a stepped-up basis for those securities is provided under current established tax laws.

In addition to the substantial tax advantages, selling to the ESOP preserves the company's independent identity. A sale to an ESOP also provides a significant financial benefit to valued employees and can assure the continuation of jobs. Moreover, selling to an ESOP allows the seller to sell all or just a part interest in the company, and to do this gradually or all at once.

To qualify for rollover treatment, the stock sold to the ESOP must be common or convertible preferred stock of a closely held domestic corporation and must have been owned by the seller for at least three years.

Note, the owner of S corporation stock that she/he sells to an ESOP is not eligible for the ESOP rollover tax benefit.  Finally, if a C corporation pays dividends in cash to ESOP participants, and the participant decides the dividends he reinvented to acquire more employer securities for his or her account, the C corporation may take a tax deduction for the value of the dividends.

Deductibility of Dividends

Employers are also permitted a tax deduction for cash dividends paid on stock which has been purchased with an ESOP securities acquisition loan, to the extent that the dividends are passed through to the employees. This provision allows companies to share current benefits of stock ownership with their employees to complement the long term benefits of capital ownership. The dividends are taxable as current ordinary income to employees. Note, this tax benefit is not available to an S corporation, and in full, an dividend of an S corporation paid in cash to ESOP participants is deemed to be an early withdrawal from the ESOP, and would solicit the ESOP participant/recipient to his/her regular income tax plus a 10% early withdrawal penalty tax.

A deduction is also available for dividends paid on ESOP leveraged stock to the extent that the dividends are used to reduce the principal or pay interest on an ESOP loan incurred to buy that stock. Dividends used in this manner are not counted towards the 25% contribution limit for leveraged ESOPs. Some ESOPs have purchased convertible preferred stock rather than common stock to assure a relatively reliable stream of dividend income to be used in servicing the loan.

The deduction is also available if the ESOP participant directs the dividend be reinvested for more company stock.

Note, as a pass through entity, an S corporation would not take a deduction for dividends used to pay ESOP debt but the S corporation may use the dividends as leveraged ESOP shares to pay ESOP debt.

Unique S Corporation Tax Advantages

Since 1998, S corporation, which as so-called “pass through” entities since there is no federal tax imposed as corporate taxable income; instead the S corporation’s taxable income is pro-rata share individual shareholders who report the taxable income of the S corporation on their individual returns.

When an ESOP trust, which is a tax exempt entity, is a shareholder of an S corporation, its pro-rata share of S corporation sponsor’s income is not currently taxed.  When ESOP participants receive a distribution from the S corporation, she/she pay an income tax on the value of the distribution.

Many S corporations that sponsor ESOPs have 100% of the S corporation stock held by the ESOP.  In this status, the S corporation’s taxable income is not currently taxed at the federal income tax.  [Most states corporate income tax laws mirror the federal tax regime.  Check with tax counsel to know the state law of the state where the S corporation is located and/or operates.]

S corporations with ESOPs holding less than 100% of the company stock have the advantage of having plenty of the cash in the ESOP to pay repurchase obligations, as the ESOP receives it pro-rata share of any cash distributions for the corporation to the shareholder.