The FAQs of an ESOP
By Dan Markowitz, CPA
May 4, 2021
What is an ESOP?
An ESOP, or Employee Stock Ownership Plan, is a tax-qualified retirement plan that provides employees a beneficial ownership stake through the sponsoring employer’s qualified securities, most commonly common stock. ESOPs are
tax-qualified retirement plans and, therefore, subject to provisions from the IRS and the U.S. Department of Labor.
How do you start an ESOP?
During an ESOP transaction, a trust is established to purchase, either from the company or owner, shares to later redistribute to employees based on pay or another equitable formula. The initial purchase of an owner’s shares is often funded by using a loan to make the initial purchase; some popular options include senior debt financing via a bank and seller financing, with shares being distributed as they are paid back by the trust. It is important that a company interested in transitioning to an ESOP consider repurchase obligations prior to establishing a trust.
For a selling owner, there are a number of attractive elements for using an ESOP. An owner can dictate their future role with the company more readily than if selling to a third-party, as well as has the peace of mind knowing that the new ownership both values and has incentive to grow the business. Financially speaking, a selling owner will receive a fair value for shares as determined by an outside, independent appraiser. This value is determined by multiple factors but is approximated to be the same as what a financial buyer might pay rather than a strategic buyer.
Who owns an ESOP?
Even if an ESOP owns a majority of the company, the board of directors appoints management to run day-to-day operations. An ESOP’s trustee votes for board members and serves a fiduciary role to the ESOP trust. In the event of major corporate changes, a trustee may use pass-through voting to give employees the ability to vote their held shares; however, the trustee does retain veto power.
Are ESOP distributions pretax?
ESOP distributions are taxed as regular income, but employee stock purchases (IRA versus cash paid) and employer stock contributions are both bought and received on a pretax basis.
What happens to an ESOP if the company is sold?
The fate of an acquired ESOP depends on purchasing company and what avenues are made available for transition of shares within the new company structure. If the purchasing company is another ESOP, it is likely that shares will roll over into the purchaser’s ESOP. The value will ultimately accrue to shareholders.
There are some cases where the purchaser will cash out shares for their fair market value (FMV) to distribute the proceeds to the ESOP trust. Ordinary income tax and capital gains taxes will be accessed with a lump-sum distribution in addition to a 10% penalty tax if the plan participant has not yet reached retirement age (59 ½ years). If rolled over, the penalty is limited to ordinary rates.
Can an ESOP roll over to IRAs, 401(k)s or other investments?
Distributions from ESOPs may be rolled over into an IRA or 401(k) plan. Additionally, an ESOP may be diversified after an ESOP participant has reached 55 years old and has participated in the plan for 10 years minimum. As much as 25% of the stock allocated may be diversified during a five-year period with the number increasing to 50% during the sixth year.
Should a startup or small business pursue an ESOP?
Many of the ESOP companies in the United States are previously family-owned businesses, but an ESOP is not for every company. An ESOP feasibility study is recommended for owners to determine if an ESOP is a right fit.
Can an ESOP help prepare for retirement?
An ESOP is a vehicle for retirement savings that provides potential growth through the company’s stock value. However, many ESOPs also offer more traditional 401(k) investment plans that encourage employees to diversify their assets as a measure of best practice for financial security.
How does ESOP vesting work?
ESOPs must comply with one of two vesting schedules by law; however, some plans may provide more expedient methods to receiving allocated funds. The two possible methods are:
- No vesting prior to three years of service, followed by 100% vesting after not more than three years have elapsed (“cliff” vesting).
- A gradual vesting process of 20% vesting after second year of service, increasing by 20% until 100% vested at six years of service.
When an employee puts shares to the company, is the employee paid in full immediately?
Per the National Center for ESOP Ownership (NCEO): “No. The company can pay out in equal annual installments, with adequate interest (a market rate) over a period not exceeding five years. For distributions over $885,000 (in 2006 dollars), the payout can be extended another year for each additional $175,000 (in 2006 dollars). The promise must be backed by adequate security. A promise to pay based on the full faith and credit of the company is not enough.”
What makes an ESOP a bad fit for some companies?
An ESOP is a poor fit for companies that are either financially unstable or whose financial projections show lack of future growth and/or are unable to appropriately manage the plan after its creation. ESOPs require expert administrative and internal accounting professionals to properly manage both their external legal requirements and obligations to internal stakeholders. If a company is not committed to establishing a trust that can effectively manage its fiduciary duties, particularly organizations that frequently experience financial volatility, startups or businesses with fewer than 25 employees, then an ESOP is not the right purchasing solution.
The Minnesota Center for Employee Ownership serves as a free unbiased source for education and resources around all forms of employee ownership. With 52,000 business owners older than the age of 55 in Minnesota exiting their business in the next five years, there is a crisis looming. What will happen to their legacy, employees, community? Business owners will look to their advisers on how best to exit. Contact us for more information on how we can be a resource for you at www.mnceo.org or reach Sue Crockett, MNCEO executive director at scrockett@mnceo.org.
This article was written by MNCPA member Dan Markowitz, CPA, a partner at Boulay. You may reach him at dmarkowitz@boulaygroup.com. Boulay serves more than 115 ESOP clients.
