Creating a vehicle to manage employee ownership of a company is a powerful way for business leaders to engage employees in its success, reward them for contributions and enable ownership transition. Six percent of businesses are currently looking at this type of plan according to a recent SunTrust study of 532 business leaders.
ESOP plans can be used in a myriad of ways to support a closely-held company’s plans and create sources for owner liquidity, often with favorable tax treatment. Yet, ESOPs are sophisticated instruments that require careful attention in their setup and proper expert advice to meet their fiduciary and regulatory strictures.
How an ESOP Works
At its core, an Employee Stock Ownership Plan – ESOP for short – is a stock trust fund managing shares that belong to the employees of the company. The plan is funded and supported by the company. The shares can be contributed by the company, or they can be purchased by the ESOP using cash funded by the company.
The shares in the ESOP are allocated to individual employees and subject to a vesting plan. Shares may be allocated in an equitable manner, based on salary level, seniority, performance or some other equitable and consistently applied formula, and plans cannot be structured to only provide the benefit to a very small group of employees or individuals. The vesting schedule generally runs from three to six years with events specified that trigger an immediate or “cliff” vest of employee shares. Vested shared can either be redeemed for cash (private companies) or for the shares themselves.
The trust fund can borrow money to acquire shares with the company’s cash contributions being used to repay the loans. This ability to borrow and provide an additional source of owner liquidity is one of the reasons ESOPs are popular in transition situations. Contributions by the company to the trust fund are tax deductible.
When to Consider an ESOP
An ESOP’s complexity makes it useful to business leaders to meet a variety of goals. ESOPs are often used by business leaders who want to:
Transition to a new management team. For an owner looking to transition out, the company can make contributions to the ESOP to buy out an owner's shares or access debt to facilitate an owner’s transition. Owners can also replace qualified securities that sell to the plan with qualified replacement assets and can defer recognition of gains. The applicability of this benefits varies based on company type (C Corporation or S Corporation) and has to be carefully structured.
Offer employee participation in company ownership. ESOPs provide an additional benefit for employees that aligns with ownership and company value. ESOPs increase employee retention: the 2010 General Social Survey funded primarily by the National Science Foundation indicated that 13% of 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 (The ESOP Association, 2012). The ESOP provides a mechanism for allocating, awarding, vesting and redemption while providing a secure structure (trust fund) for plan participants.
Create a source of owner liquidity in a privately held company. Owners of privately held companies can use an ESOP to create a market for their shares and provide a mechanism (loan to the ESOP) to fund that transaction. For a company with growing cash flow year over year, this mechanism can allow an owner to begin to access equity value created at a rate faster than the current year’s cash generation.
Add leverage to the company at favorable tax rates. An ESOP can borrow money to be repaid as the company makes cash contributions to the plan. It unlocks another financial asset that the company or individual selling stock to the plan can use to secure debt. It does so with full deductibility of contribution and financing costs.
Understanding the Fine Print
The rules and regulations around ESOP plans and their trust components vary depending on company structure and plan setup. Keep in mind that technical knowledge becomes important in their setup and administration, and there are costs for initial set up and ongoing administration of an ESOP. To note:
- Tax Treatment. There are special considerations on treatment of S corporation income and distributions that can allow S corporation income to flow to the ESOP without immediate incursion of tax liability. Contributions of cash and stock are tax deductible. There are limitations to the use of ESOPs with partnerships and professional corporations. Talk to a tax professional to understand how the law and these benefits will work with your company.
- Valuations. You will need regular valuations. Fiduciary duty in creating trustees for and avoiding conflict with the ESOP trust fund has to be carefully worked out. Your SunTrust Relationship Manager can help you explore ESOP possibilities and funding for your company.
- Redemption of stock. ESOP plan participants in closely held companies must be able to redeem their stock for cash in a prescribed set of circumstances. Plan design needs to consider the cash demands of these redemptions.
- Participating employees see timing and tax deferral benefits with the stock they receive under the plan. They also have protected voting rights that vary based on company type.
Next Steps – Getting Started
Whether used for employee engagement and ownership participation or to facilitate a transition, ESOP evaluation should flow from your Six Year Plan. The plan and thinking behind it will guide you in deciding how an ESOP will work to meet your objectives.
Engage all of your advisors – CPA, attorneys, financial advisors and others who you turn to for strategic and financial advice. In particular, talk to your SunTrust Relationship Manager. Special expertise is needed to set up the trust and technical aspects of the plan, and your banker can help you find the right resources to support you. Also, given the benefits of being able to finance the contributions to the plan, your SunTrust Relationship Manager can help you understand the mechanics of how ESOP financing can work with your company while helping you tie to use of an ESOP to meeting your six year plan.