Using an Employee Stock Ownership Plan to Transfer Business Ownership
As a business owner, you have a variety of ways to transition ownership of your business when you're ready to retire or move on to a new adventure. Most business owners think of transitioning ownership to a family member or selling the company to a third party, but an often overlooked option is to sell the business to an employee stock ownership plan (ESOP).
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What Is an ESOP?
An employee stock ownership plan is a tax-qualified retirement plan similar to a 401(k). But unlike 401(k)s and other retirement plan options, the ESOP is invested primarily in shares of stock of the sponsoring employer. A trust holds the shares of the business for employees, making the employees the beneficial owners of the company they work for.
An ESOP offers a unique way to transition business ownership while maintaining continuity and rewarding employees.
Characteristics of Companies that Benefit from an ESOP
Not all companies are ideal candidates for an employee stock ownership plan. Companies that thrive with an ESOP typically share the following features:
Profitable with strong cash flow. ESOPs work best when a company has steady profits and strong cash flow.
Mature business structure. Companies with established management teams and well-developed processes tend to perform well under ESOP ownership because the management team plays a crucial role during the transition and ongoing business success.
Engaged workforce. An ESOP involves employees becoming stakeholders in the business. Companies with a committed and engaged workforce that is invested in the company’s success are more likely to benefit from this ownership structure.
An owner with a significant portion of their net worth tied up in the business. Selling to an ESOP ensures a fair market value for selling shares of a closely held company. The business owner can sell to the ESOP at their own pace, continue working for a while before withdrawing into a limited role, or exit quickly.
Advantages of Transitioning Ownership with an ESOP
An ESOP offers several advantages over other forms of ownership transition, such as selling to an external buyer or merging with another company.
Tax Benefits for the Business Owner
ESOPs come with significant tax advantages for both the selling owner and the company. Sellers can defer and possibly even avoid capital gains when selling company stock to an ESOP if:
The ESOP entity is a C Corporation at the time of sale
The ESOP owns at least 30% of the company immediately after the sale
The owner reinvests the sales proceeds into U.S. domestic corporation stocks and bonds within a 15-month window that starts three months before the sale date and ends 12 months after the sale date.
S corporations sponsoring ESOPs qualify for different income tax benefits. The portion of the business owned by the ESOP trust fund is exempt from federal (and potentially state) income taxes.
ESOP Financing Flexibility
There are generally two ways to finance an ESOP:
Leveraged ESOP. The company creating the plan finances the initial stock purchase with money borrowed from a bank or the selling shareholder(s).
Non-leveraged ESOP. The company self-finances the transaction through cash or company shares. The employer can deduct company contributions in the year they make the payment.
However, many companies find it challenging to self-fund an ESOP with cash because ESOPs are expensive to start up. The company must pay legal costs to set up the plan and keep it current and compliant with IRS and Department of Labor (DOL) rules.
According to The National Center for Employee Ownership (NCEO), ESOPs typically cost at least $125,000 to set up and another $20,000 to $35,000 annually for administration and valuation—more if you hire an outside trustee.
Increased Employee Productivity
According to a study from Rutgers University, ESPOs increase sales, employment, and sales per employee by about 2.3% to 2.4% per year over what would have been expected without an ESOP.
When employees have a stake in the company's success, they're more motivated to contribute to corporate performance, growth, and profitability.
Retirement Security for Employees
For employees, ESOPs provide a retirement benefit without requiring personal investment. Employees accumulate company shares, and when they leave or retire, they receive their shares' value.
A study conducted by the NECO found that employee-owners of S corporation ESOPs have, on average, more than double the retirement savings compared to participants of a traditional employer-sponsored retirement plan.
Steps for Transitioning to Employee Ownership
If an ESOP is the right move for your closely held company, here's a look at the steps involved in moving from traditional ownership to an ESOP. Keep in mind that transactions can take anywhere from six months to over a year, depending on the complexity of the transaction, so it's crucial to plan ahead.
Feasibility study. Before committing to an ESOP, conduct a feasibility study to determine if the company can afford to establish and maintain the plan. This study includes a financial assessment to ensure you have the cash flow to support the ESOP transaction, ongoing contributions, and administrative expenses.
Company valuation. The next step is to hire an independent appraiser to determine the company's fair market value. You'll use this valuation to set the price at which the ESOP purchases shares of the company stock.
Structure the ESOP. Work with your attorney and other advisors to design the ESOP structure. You'll need to decide on the percentage of ownership to transfer, how you'll finance the plan (leveraged vs. non-leveraged), and the timeline for the transfer. You also need to appoint a trustee to represent the employees in the transaction.
Finance the ESOP. Most companies opt for a leveraged ESOP to preserve cash flow. The company uses a loan to buy the owner’s shares, and the ESOP repays the loan using future company earnings. The company can make tax-deductible contributions to the ESOP to cover the loan payments.
Transition and communication. During and after establishing the ESOP, it’s critical to communicate the changes to employees. Participants must understand how the ESOP works, their rights as new shareholders, and how their efforts directly impact the company’s performance.
Ongoing plan management. Once the ESOP is in place, the company must manage the plan. This includes making regular contributions to fund employee accounts, ensuring compliance with Employee Retirement Income Security Act (ERISA) regulations, and conducting annual valuations.
Ready to Transition with an Employee Ownership Plan?
An ESOP can be an excellent way to transition ownership of private companies, benefiting both owners and ESOP participants while preserving the company’s legacy.
To discuss whether employee stock ownership plans might fit your succession planning goals, contact Slate today. We can help guide you through the process and ensure a smooth transition for you and your employees.