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Benefits and Drawbacks of ESOPs


Wednesday, October 12, 2011


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An Employee Stock Ownership Plan ("ESOP") is a tax-qualified defined contribution employee benefit program intended to invest in the stock of the plan sponsor company. To establish an ESOP, the sponsor company creates a trust with the sole purpose of holding shares of the company. To acquire shares for the trust, the company may contribute newly issued shares, purchase shares with cash on-hand, or, as is more frequently the case, borrow funds from an outside lender against future earnings. Once in the trust, ESOP shares are allocated to individual employee accounts according to a pre-determined formula (for example, length of employment). When an employee departs, the company is obligated to purchase the employee's shares at fair market value.

As a tax-qualified employee benefit program, ESOPs can be used to achieve a variety of individual and corporate objectives at significant tax savings. However, ESOPs are not for every company as they can entail significant administrative expenses and can be cumbersome to administer. This article will explore some of most notable benefits and drawbacks of an ESOP.

ESOP BENEFITS

Tax Benefits to Retiring Owners and Large Shareholders

Retiring shareholders frequently have large holdings of low-basis stock that cannot be sold without incurring sizeable capital gains liability. However, under Section 1042 of the Internal Revenue Code (the "Code") a shareholder of a C Corporation may, under certain circumstances, eliminate a large part of his or her capital gains liability. To take advantage of this provision, the shareholder must sell at least 30% of his or her company shares back to the company's ESOP and then use the proceeds from that sale to purchase other qualified investments. The tax savings are realized by deferring the gain or by the shareholder leaving the newly acquired investments to his or her heirs who receive "stepped up basis" tax treatment upon the shareholder's death. 

Tax Benefits to the Company

One of the most attractive benefits of an ESOP is that it can be used to cost-effectively finance growth through its tax-privileged status. An ESOP has the ability to borrow money to purchase shares of the company. Once the ESOP purchases the shares, the company has use of the borrowed funds. The tax savings are realized when the borrowed funds are repaid. Because ESOP contributions are tax deductible when the company makes contributions to the ESOP to repay the borrowed funds, the contributions, within certain limits, are tax deductible. As a result, the ultimate cost of borrowing to the company is significantly reduced and a cash flow advantage is gained.

An additional tax benefit available to an S Corporation is that an ESOP presents it the opportunity to reduce its federal (and in some cases state) income taxes significantly. The Code exempts an S Corporation's ESOP from income taxes. Thus, the percentage of a company that is owned by its ESOP is exempted from federal income taxes. For example, if an S Corp's ESOP owns 70% of the shares of the company, the company will only pay federal income tax on the 30% of the shares not owned by the ESOP. These tax savings can be used to finance growth.

Benefits to the Employees

ESOPs can assist in fostering employee morale and attracting and retaining talented employees since employees who participate in an ESOP are likely to have a greater sense of ownership. Beyond this, employees receive a tax benefit from an ESOP in that their accounts grow tax-free. As with most retirement plans, employees in an ESOP may roll-over their contributions into another qualified retirement plan without paying tax on the distribution. However, it should be noted that employees in an ESOP, even if they maintain outside retirement accounts, frequently lack significant diversification among their investments due to the fact that the ESOP only owns stock in the plan sponsor company and, thus bear all the risks associated therewith.

From an employer's perspective, it is important to note that an ESOP cannot be used as a merit-based reward system. Share allocations must be made relative to pay or some other similar formula. Additionally, it is a frequent misconception among employers that creating an ESOP obligates an employer to share sensitive financial information with employees. In fact, employees are only entitled to receive certain ESOP documents (Summary Plan Description, Individual Benefit Statement and Annual Report) and not permitted unrestricted access to the company's books.

ESOP DRAWBACKS

Drawbacks to the Retiring Owner/Employee

Even without an ESOP in the picture, a large shareholder (usually a founder or owner) looking to cash out all of his or her shares at retirement is likely to have difficulty obtaining a full cash payment. Since the funds used to re-purchase the shares come from the company, re-purchases are contingent upon the company having the funds available. As a result, a large shareholder will frequently be asked, or required, to accept a payment plan when redeeming his or her shares. For the length of the payment plan, the selling shareholder continues to bear the risk of the company encountering financial difficulties. If a company plans to incur substantial debt to start an ESOP, large shareholders should be especially mindful of how repayment of the debt could make it even more difficult for the company's to re-purchase their shares.

Drawbacks to the Company

An ESOP can create serious cash-flow issues for a company. If a company borrows money to fund an ESOP, it will have to allocate significant future earnings towards repayment. For a company that is accustomed to a conservative debt-to-equity ratio, this can be a significant change. The company must also be prepared to buy back shares of retiring employees. If a company has a large percentage of employees nearing retirement age, there is a very real potential of a cash drain.

ESOPs can be expensive to administer. As a tax-qualified retirement plan there are substantial federal regulations and reporting requirements that must be complied with. It has been estimated that start-up costs can run anywhere between 3% and 6% of the value of the initial plan. These costs, at least in the short-term, may outweigh any potential tax benefits. Additionally, legal and accounting expenses for yearly compliance and reporting requirements can run in the thousands of dollars. As part of the administrative expenses, Federal regulations require a valuation of ESOP shares by an independent third party on a regular basis.

A common misconception of business owners is that by establishing an ESOP they will lose control over their company. In fact, ESOPs do very little to dilute the control of the owner. By law, the ESOP shares are owned and voted on by an ESOP trustee who is appointed by the Board of Directors of the plan sponsor company. As a result, ESOP participants are only permitted to vote in certain situations where required by law. These situations rarely come up in the day-to-day operation of a company and usually only involve major decisions regarding the company's future such as mergers, restructuring, recapitalization or liquidation.

CONCLUSION

An ESOP can be an effective tool to transition a retiring business owner, achieve tax-advantaged growth and build employee morale. However, as a tax-qualified employee benefit program, an ESOP comes with significant legal obligations. When considering an ESOP, a company would be prudent to consult with an experienced attorney and accountant/business consultant for an informed opinion as to whether the potential benefits outweigh the drawbacks to the company.


This article is intended to serve as a summary of the issues outlined herein. While it may include some general guidance, it is not intended as, nor is it a substitute for, legal advice. Your receipt of Good Company or any of its individual articles does not create an attorney-client relationship between you and Sheehan Phinney Bass + Green or the Sheehan Phinney Capitol Group. The opinions expressed in Good Company are those of the authors of the specific articles.