Employee Stock Ownership Plan

Key Takeaways

• An Employee Stock Ownership Plan can create a market for a private company’s shares without requiring the owner to find an outside buyer.
• An ESOP can purchase part or all of a company, allowing owners flexibility in how much they sell and whether they remain involved.
• ESOP transactions can provide significant tax advantages to the selling owner, the company and participating employees.
• Leveraged ESOPs commonly use bank debt, seller financing or both to fund the purchase of shares.
• Owners should evaluate cash flow, valuation, management succession, repurchase obligations and transaction costs before choosing an ESOP exit strategy.

What Is an Employee Stock Ownership Plan?

An Employee Stock Ownership Plan, or ESOP, is an employer-sponsored retirement benefit plan that holds company stock for employees through a trust. Employees generally do not purchase the shares themselves. Instead, the company contributes cash or stock to the trust, or the ESOP borrows money to acquire shares. Shares are then allocated to employee accounts under the plan’s rules. Unlike a traditional retirement plan invested primarily in outside securities, an ESOP is designed to hold stock in the sponsoring company. Employees receive the value of their vested shares when they retire or leave the company.

How an ESOP Works as a Business Exit Strategy for Owners

An ESOP allows a private company owner to create a buyer for some or all of the company’s stock. The company establishes an employee stock ownership trust, or ESOT, which purchases shares at no more than fair market value based on an independent valuation. This can be attractive when an owner wants liquidity but also wants to preserve the company’s management team, employees and legacy. Owners may sell a portion of their holdings or the entire company and can potentially remain involved afterward. An ESOP exit strategy can therefore provide more flexibility than a traditional third-party sale.

The Tax Benefits an ESOP Provides at Every Level of the Transaction

The ESOP tax benefits can extend to the seller, company and employees. Company contributions to an ESOP are generally tax-deductible within applicable limits, including contributions used to repay qualifying ESOP acquisition debt. An S corporation generally does not pay federal income tax on profits attributable to the ESOP’s ownership percentage. Employees typically are not taxed when contributions are made and instead recognize tax when benefits are distributed. Certain C corporation sellers may also defer capital gains through a section 1042 rollover when qualifying requirements are met. Broader transaction planning may also need to consider issues such as Depreciation Recapture.

How Leveraged ESOP Transactions Are Financed

In a leveraged ESOP, outside financing is used to help the trust purchase a larger block of company shares. Typically, the company borrows from a bank, private lender, selling shareholder or combination of sources. The company then lends those funds to the ESOP trust, which uses the money to purchase shares from the selling owner. Over time, the company makes contributions to the ESOP, allowing the internal loan to be repaid and shares to be released into employee accounts. Seller notes are also common, particularly when outside financing does not cover the entire purchase price or in larger ESOP transactions.

What Business Owners Should Evaluate Before Committing to an ESOP

Owners should first determine whether the company generates enough cash to service transaction debt while continuing to fund operations. Future repurchase obligations also matter because private companies may eventually need to buy shares from departing employees. Owners should consider transaction costs, independent valuation requirements, regulatory compliance and whether successor management can operate the company after the seller leaves. An ESOP may also produce a different valuation than a strategic buyer willing to pay for synergies. Corporate structure matters as well. More complex restructuring may involve planning concepts such as an F Reorganization, depending on the circumstances and objectives.

FAQ

What percentage of a company can an ESOP own?

An ESOP can own a portion of a company or 100% of it. Owners have considerable flexibility in deciding how much stock to sell. A partial transaction can provide liquidity while allowing existing shareholders to retain ownership and remain involved in the business.

Can an S corporation sponsor an ESOP?

Yes. S corporations can sponsor ESOPs. Profits attributable to the ESOP’s ownership interest generally are not subject to federal income tax at the shareholder level. A company that is 100% ESOP-owned can therefore receive particularly significant ESOP tax benefits.

How does an ESOP affect employees when the company is sold?

Employees generally receive company shares through their ESOP accounts without purchasing them personally. As shares are allocated and employees vest, they build an ownership benefit. When employees retire or leave, they generally receive cash representing the value of their vested shares.

What happens to unvested ESOP shares when an employee leaves?

Employees are generally entitled only to the vested portion of their ESOP account when they leave the company. Unvested benefits may be forfeited according to the plan’s vesting schedule, terms, and applicable retirement-plan rules. Employees should review the plan documents to understand how their shares and benefits will be handled when employment ends.

How BT Can Help

For more than four decades, Bennett Thrasher has provided businesses and individuals with strategic business guidance and solutions through professional tax, audit, advisory, and business process outsourcing services. Contact Bennett Thrasher’s Employee Benefit Plan Audit Team, or call us at 770.396.2200.