ESOPs can be an opportunity to generate significant cash flow and personal wealth for the owner and the other ESOP participants—through accelerated business growth and improved operational performance.
ESOP Expertise and Experience
Your CFO Solutions provides the insight and expertise and experience you need to both convert and subsequently manage an ESOP, including:
- Unbiased advice and guidance on ESOPs as an strategic option for business owners
- Guidance through the transition process to an ESOP, including securing financing and managing the relationships with the banking community
- Offer ESOP expertise as an independent advisor and outside board member—in line with best practices
Why Choose an ESOP?
ESOPs are ideal for business owners who strive for excellence through a positive corporate culture, and employee engagement, and where the owner:
- Is open to offering partial ownership for their employees
- Do not wish to sell to a competitor or add new partners
- Do not plan to transferring wholesale to a family member
In addition ESOPs also:
- Provide an alternative exit strategy option for the business owner
- Create higher engagement from the employees, often resulting in higher sales, customer satisfaction and profitability
- Free up funds, tied into owner equity, by sell a portion of their business—typically around 1/3 of the business
- Allow the owner to retain control of the business
- Provide tax benefit (with appropriate planning), for example:
- Option to defer tax on the sale
- Can become a tax free corporation
Many companies have recognized the value in converting to an Employee Owned Stock Plan (ESOP). Employee Stock Ownership Plans (ESOPs) are trusts that acquire, hold or sell the company’s stock for the benefit of employees. An ESOP allows employees to become owners of the stock in their company.
For shareholders, ESOPs provide an excellent way to ensure liquidity and to minimize business disruptions. For employees, ESOP participation provides a way to offer an incentive for future business growth.
For companies considering an ESOP, an outsourced CFO service can help your company convert to an ESOP-centered organization while providing education and guidance on how to proceed with the conversion.
Unlike many other outsourced CFOs, Your CFO Solutions has extensive experience in assisting companies to convert to an ESOP. Your CFO Solutions assist in the process of converting to an ESOP-centered organization while providing thorough education and guidance on post conversion matters.
What is an ESOP?
A company establishes an ESOP as a trust, whereby it makes yearly tax-deductible contributions to the trust in the form of new or treasury stock, cash to buy existing shareholder stock, or pay down debt used to acquire company stock. Shares in the ESOP trust are allocated to individual employee accounts on the basis of relative pay or some more equal formula.
As employees accumulate seniority with the company, their shares in the account become vested. Employees must be 100% vested within three to six years, depending on whether vesting is done on a cliff vesting or gradual basis (the same vesting rules as for any profit sharing plan)
On the employee side, employees who participate in the ESOP have accounts within the ESOP to which stock is allocated. It is important to note, employees do not buy the stock with payroll deductions or make any personal contribution to acquire the stock. Plan participants accumulate account balances and begin the vesting process after one year of full-time service. Contributions to the ESOP in the form of cash or stock, accumulate until an employee departs from the job. At this time the departing employee receives their stock held in trust, which the company purchases from the departing employee at its fair market value.
A departing employee will receive their stock from their employer, at which time the company must buy the stock back at fair market value. However, the rules for private companies dictate that an annual outside evaluation must be conducted to determine the price of their shares. Further, in private companies, employees must be allowed to vote according to their allocated shares on major issues affecting the company. This is contrasted with public companies, whereby employees must be able to vote all issues.
Upon departing the company, an employee may elect to receive their distribution as either a lump sum installment on an immediate or deferred basis.
Benefit of ESOPs
In light of the advantages ESOPs offer, one should not be shocked to learn that a growing number of companies are using ESOPs. In fact, today, there are approximately 7,000 active plans, with 13.5 million participants. ESOPs popularity rests in the numerous benefits offered to shareholders and employees.
One of the primary benefits of ESOP ownership rest in the fact that it can be accomplished on a tax-advantaged basis. The tax advantages associated with ESOPs are significant for the selling shareholders and the company, given that the Internal Revenue Code and some state tax codes contain many incentives for ESOPs for the sponsoring company and employees.
Deductibility of ESOP Contributions
Employer contributions to the ESOP are tax-deductible up to a limit of 25% of covered payroll. For C corporations who have set up a leveraged ESOP, the 25% limit does not include contributions to pay interest on the loan. The contribution and deduction limits for an S corporation ESOP are the same as those for a leveraged C corporation ESOP.
Deductibility of Dividends Paid on ESOP-Held Stock
Companies that sponsor ESOPs can deduct dividends paid into the ESOP if the following occurs. First, dividends must be paid in cash to ESOP participants, dividends must be applied to a leveraged ESOP’s loan payments and dividends must be voluntarily reinvested in company stock in the ESOP by employees. Dividend deductions are not subject to the 25% limits described above for ESOP contributions.
Taxing ESOP Benefits
Employees do not pay tax on stock allocated to their ESOP accounts until they receive distributions. At the time of the distribution, if the employee is younger than age 59 1/2 or if the employee has been terminated from employment, the applicable tax rate applies and an additional 10% excise tax unless the benefits are rolled into an IRA or a successor plan in another company.
Business owners enjoy a broad range of exit options, including selling to an external buyer, such as a competitor or other player in the same market, or industry investors such as private equity firms and wealthy individuals; or an initial public offering (IPO). As a practical matter, a vast majority of many business owners have far fewer suitable exit options.
ESOPs are commonly used as a means of exit planning their exit strategy. In this case, rather than sell the company to an external party, the ESOP allows for ownership to transfer by allowing owners to reward their employees and managers with a stake in the business. When using an ESOP as an exit planning strategy members of management retain their positions, which allows for a smooth transition. While other exit strategies can have a negative impact on an organization’s culture, an ESOP can ensure that company culture remains intact thus creating a smoother transition process, as the interests of owners, management, and employees are aligned.
According to the Journal of Accountancy, “A significant amount of research and empirical data shows that ESOP companies outperform their non-ESOP closely held counterparts. The studies reinforce what is already generally known among business authors and consultants: that open sharing of information is a superior organizational structure, that typically contributes to longer-term financial success.” A great deal of ESOP owning companies’ success, can be attributed to the fact that ESOPs offer an excellent incentive for employees who can receive significant retirement benefits at no monetary cost to them. Further, an ESOP is a great way to enhance the company’s ability to recruit and retain top talent. Effective and ongoing employee communications to encourage employees to think and act like owners is necessary to generate these benefits.
Converting to ESOP Ownership
While the advantages of ESOPs are well documented, it is important to understand that an ESOP is not a good fit for every company or situation and can involve a significant regulatory compliance burden. For example, federal regulations governing ESOPs are complex, and can place significant regulatory requirements on how an ESOP is administered. As such, it is critical to consult with advisors who are knowledgeable in the potential regulatory traps unique to ESOPs.
As discussed above, an ESOP qualifies for tax-favored advantages. In order to qualify for these tax benefits, the ESOP must comply with various participation, vesting, distribution, reporting and disclosure requirements as established by the IRS. ESOPs are also subject to the regulations outlined in the Employee Retirement and Income Security Act of 1974. Failure to comply with these regulations can effectively undo any benefits gained by ESOP participation. As a “tax-qualified retirement plan”, ESOPS fall under the same regulations as other tax-qualified retirement plans. Therefore, an ESOP must:
- Be in writing
- Be held in trust for the benefit of the plan participants
- Not discriminate in favor of “highly compensated” employees
- Cover a reasonably broad cross-section of the company’s employees
- Allow employees to become vested in their plan benefits according to minimum standards
As a tax-qualified retirement plan designed to invest primarily in “qualifying employer securities,” an ESOP company must take steps to ensure that the ESOP is designed to “invest primarily in qualifying employer securities.” What constitutes a qualifying employer security can be complicated and if not conducted properly, can disqualify the ESOP from potential tax benefits.
Further, how the ESOP is structured can have a significant impact on how the ESOP must be managed. For example, most of the privately held U.S. companies that use ESOPs have been structured as S corporation ESOPs, also known as S ESOPs. While other ESOP-focused corporations opt for a different ownership structure, in light of the need for control and flexibility with managing and governing the corporation. Regardless of the type of structure selected, there are a variety of practical and compliance considerations that must be understood and implemented.
Your CFO Solutions can take your company through the processes involved with converting to and operating as an ESOP company. Unlike many other outsourced CFOs, Your CFO Solutions has extensive experience in assisting companies to convert to an Employee Owned Stock Plan (ESOP). Your CFO Solutions can help your company convert to an ESOP-centered organization, while providing thorough education and guidance on how to proceed after the conversion and ultimately make the most of the ESOP structure.
Contact Your CFO Solutions for more information on how an outsourced CFO can benefit your company.