United States: Win-win Dynamics: Exploring How ESOP Transactions Benefit Owners And Employees

Most business owners have likely heard the term "ESOP" but may not know exactly what it is. An ESOP is an Employee Stock Ownership Plan under which the owners of a corporation sell all, or a portion of, their stock in the business to their employees.

The creation of an ESOP benefits the corporation's owners and employees. For the owners, the sale of their shares to the ESOP is viewed as an exit strategy from their business. For the employees, the ESOP creates a retirement plan for employee ESOP participants, and they become owners of the company and directly benefit from its success.

An additional benefit of an ESOP for business owners is that they can sell all shares in their company to the ESOP and completely exit the organization, or they can sell a minority of their shares and still maintain control over the company. This flexibility is not always available to owners should they choose to sell their business to an independent buyer.

Steps for establishing an ESOP

A company creates an ESOP by establishing an employee stock ownership trust and adopting a plan that establishes the terms for administering the ESOP. Among other items, the plan always sets forth the qualifications for employees to become ESOP participants (e.g., hours of employment), the employee vesting schedule, and whether a board of trustees or an independent trustee will administer the ESOP.

Once the ESOP is established, it needs capital to purchase shares of the company from the owners. The most seamless way to initiate this transaction is for the ESOP to issue a promissory note to the selling owners as consideration for the sale of the stock. Under this construct, the company makes an annual distribution to the ESOP, and the ESOP makes a payment under the promissory note to the selling owners.

The more conventional procedure to initiate an ESOP transaction is for the company to obtain a loan from an outside lender (the outside loan) for the purchase price of the owners' shares plus additional working capital. The company then takes the proceeds of the outside loan and loans the proceeds to the ESOP (the inside loan). The ESOP uses the proceeds from the inside loan to purchase the shares from the owners. The company stock purchased by the ESOP is held by the ESOP trustee in an account as collateral for the inside loan. Each year, the company makes a contribution to the ESOP. The ESOP then uses these funds to pay back the inside loan to the company. Upon receipt of the funds from the ESOP, the company repays the outside loan with the outside lender. As the ESOP pays back the inside loan to the company, the trustee releases shares of the company stock held in the trust's collateral account, and these shares are then allocated to the participants of the ESOP pursuant to the plan.

Tax advantages of ESOPs

The creation of an ESOP and the closing of an ESOP transaction can also be tax advantageous to the selling owners, the company and the ESOP employee participants. For example, cash contributions and contributions of stock by the company to the ESOP are tax deductible. If the company is an S corporation, the company does not pay federal income tax, and sometimes state income tax, on the percentage of income attributable to the ESOP.

If the company is a C corporation and the ESOP purchases at least 30% of the company's stock from the owners, the owners can defer taxation on the sale of their stock by properly reinvesting the proceeds from the sale into certain securities. Instead of receiving a cash distribution from the ESOP when the ESOP buys back shares of the company attributable to an employee, the employee may roll their distribution into an IRA or a similar retirement account.

An ESOP can be a good alternative for owners seeking to retire while providing for their company's employees, and it can be particularly attractive when selling a family business if the next generation has no interest in continuing the enterprise. Owners' sale of their companies to ESOPs is becoming more common. If the company has a strong culture and motivated employees, business owners looking to exit their businesses in the short term may wish to create an ESOP and the sale of all, or a portion, of their shares to the ESOP.