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Tax-Advantaged
Shareholders can defer or eliminate capital gains taxes on their sale proceeds, while their businesses gain corporate tax deductions and can become income tax-free entities.
Customizable
Partial sales are common, and transactions can be tailored to buy-out targeted shareholders. Employee-owned companies can also engage in future M&A deals.
Legacy-Focused
Employee ownership enables firms to remain independent and rooted in their communities. Founders, family, and other shareholders can maintain equity and meaningful roles.
Embodying Conscious Capitalism
Employee ownership is not a handout. The benefits are meaningful, but the opportunities are earned.
Eligible staff are allocated stock over time, and those shares are subject to vesting. In the long run, employee owners gain skin in the game and wealth-building opportunities.
This helps foster "ownership cultures" that can propel businesses and their communities to new heights. Research has shown that employee owners and their firms outperform their peers in terms of business metrics and standards of living.
EMPLOYEE OWNERSHIP BASICS
Are there different types of employee stock ownership plans?
Yes. The two most common types are contributory and leveraged ESOPs. Contributory plan sponsors periodically issue new shares to an employee trust. Cash can also be contributed to a trust so that it may purchase company stock. In a leveraged plan, an employee trust borrows money to purchase an equity stake from a company sponsor.
Are partial sales permitted?
Yes. Also known as minority ESOP transactions, these strategies enable targeted shareholder exits and partial liquidity events. Sponsor companies maintain the freedom to entertain various transaction options while individual shareholders retain equity. Additional shares can be sold to a company's employee stock ownership trust at a later date.
What laws govern ESOPs?
The Employee Retirement Income Security Act of 1974 (ERISA) codified the modern ESOP, set plan standards, and gave the Department of Labor oversight jurisdiction. Subsequent, bipartisan legislation has both clarified regulations and expanded the set of tax incentives available to ESOP stakeholders.
HOW ESOPs WORK
How do employee stock ownership trusts buy company stock?
An employee trust acquires shares on behalf of ESOP participants. A trustee negotiates the purchase price based on an independent valuation. Employees do not pay out-of-pocket for stock. Instead, the sponsor company secures financing and repays those loans on the trust's behalf.
How are employee-owned shares allocated?
Eligible employees receive share allocations proportional to their annual W-2 wages. In a leveraged ESOP, stock is usually parceled-out over multiple years. Similar to 401(k) plans, there’s generally a three-to-six-year vesting period for allocated stock. The details are determined before the plan is formed and outlined in the ESOP plan document.
When and how can employee owners sell shares?
In general, when an ESOP participant retires or departs a sponsoring company, all their shares are sold back to the plan sponsor. Shares are priced at a current valuation, and the sale is orchestrated by the employee stock ownership trust. Plan participants can roll their proceeds into another qualified retirement plan.
ESOPs AS M&A ALTERNATIVES
How do ESOP sales differ from other transactions?
ESOPs offer privately-held companies continued independence, unique tax advantages, and employee benefits. Post-transaction oversight of an employee-owned business rests with the firm’s board of directors, and selling shareholders often maintain meaningful roles.
Are certain companies better suited for leveraged ESOPs?
Leveraged ESOPs are industry-agnostic, but private companies with taxable income and at least 10 employees are generally better candidates. Common use cases include family business ownership transitions, management buyouts, partner exits, and partial liquidity events for owners who want to stay with their companies.
How do selling shareholders receive cash at close?
Many third-party lenders, including major banks and funds, help finance leveraged ESOPs. These loans are secured by plan sponsors on behalf of their employee trusts. Senior debt, without personal guarantees, is commonly used to provide up-front cash to sellers. Seller notes are also a standard ESOP financing component.
TAX ADVANTAGES
What is a 1042 Rollover?
An ESOP-exclusive benefit, this tax-deferral strategy enables selling shareholders to defer and potentially eliminate capital gains burdens on their sale proceeds. To earn the benefit, a seller must reinvest their proceeds in Qualified Replacement Property within 12 months of their ESOP transaction date.
Can employee-owned companies earn tax incentives?
Yes. When shares are transferred to an employee stock ownership trust, sponsor companies may earn state and federal income tax deductions equal to the fair market value of that stock. In addition, 100% ESOP-owned S corporations can become income tax-free in perpetuity.
Are employee owners entitled to tax benefits?
ESOP participants can roll plan benefits into other tax-deferred retirement accounts, including 401(k)s and IRAs. Rollovers must be completed within 60 days of a plan distribution. Otherwise, distributions and dividends are subject to standard taxes and early withdrawal penalties.
FORMING A LEVERAGED ESOP
Typically, what is the first step in a plan formation?
Interested companies often commission a financial analysis and feasibility study, led by an experienced advisor. This work can help stakeholders quantify plan benefits and costs, review structuring options, ascertain fair market valuation, and appreciate the overall viability of a potential ESOP.
How is a trustee selected?
Ideally, a selection committee, designated by the sponsor company’s board and comprised of key employees, will select the trustee. An interview process featuring several qualified candidates is typical. To determine best fit, the committee will consider multiple factors, including candidates’ independence, experience, and competence.
How is an ESOP sale price determined?
A sponsor company and its ESOP trustee negotiate final transaction pricing. An employee stock ownership trust cannot pay more than fair market value, an IRS standard that is typically a composite of discounted cash flow modeling, public market comparisons, and precedent transaction analysis.
MANAGING ESOP-OWNED COMPANIES
What is an ESOP trustee’s role?
A trustee is the employee stock ownership trust’s shareholder of record. They have a fiduciary obligation to all plan participants. During an ESOP formation, a trustee represents and negotiates on employees’ behalf. Post-transaction, they ensure the ESOP’s terms are followed and executed by the plan’s sponsor.
Who runs an ESOP-owned business?
The company’s board of directors oversees management and operations. The ESOP trustee typically does not serve on the board. Instead, the trustee maintains an oversight role and votes the employee-owned shares in the event of a major transaction, such as a sale, merger, acquisition, or recapitalization.
Can a plan be modified or terminated?
Yes. With a trustee’s consent, plan terms can be modified. In addition, ESOP financing can be restructured, and follow-up transactions—including secondary sales, stock repurchases, and plan terminations—are common. Under certain circumstances, a sponsor company’s board of directors can replace a plan’s trustee.
