An Employee Stock Ownership Plan, or ESOP, is a qualified retirement program through which employees receive shares of the corporation's stock. Like cash-based retirement plans, ESOPs are subject to eligibility and vesting requirements and provide employees with monetary benefits upon retirement, death, or disability. But unlike other programs, the funds held in ESOPs are invested primarily in employer securities (shares of the employer's stock) rather than in a stock portfolio, mutual fund, or other type of financial instrument.
ESOPs offer several advantages to employers. First and foremost, federal laws accord significant tax breaks to such plans. For example, the company can borrow money through the ESOP for expansion or other purposes, and then repay the loan by making fully tax-deductible contributions to the ESOP (in ordinary loans, only interest payments are tax deductible). In addition, business owners who sell their stake in the company to the ESOP are often able to defer or even avoid capital-gains taxes associated with the sale of the business. In this way, ESOPs have become an important tool in succession planning for business owners preparing for retirement.
A less tangible advantage many employers experience upon establishing an ESOP is an increase in employee loyalty and productivity. In addition to providing an employee benefit in terms of increased compensation, like cash-based profit sharing arrangements do, ESOPs give employees an incentive to improve their performance because they have a tangible stake in the company. "Under an ESOP, you treat employees with the same respect you would accord a partner. Then they start behaving like owners. That's the real magic of an ESOP," explained one executive in Nation's Business. Some experts also claim that ESOPs—more so than regular profit sharing plans—make it easier for small businesses to recruit, retain, and motivate their employees.
GROWTH OF ESOPS
The first ESOP was created in 1957, but the idea did not attract much attention until 1974, when plan details were laid out in the Employee Retirement Income Security Act (ERISA). The number of businesses sponsoring ESOPs expanded steadily during the 1980s, as changes in the tax code made them more attractive for business owners. Though the popularity of ESOPs declined during the recession of the early 1990s, it has rebounded since then. According to the National Center for Employee Ownership, the number of companies with ESOPs grew from 9,000 in 1990 to 10,000 in 1997. By 1999, there were 11,000 ESOPs with a total of 9.5 million employee owners, according to the national ESOP Association. This steady growth stems not only from the fundamental strength of the economy during the 1990s, but also from small business owners' recognition that ESOPs can provide them with a competitive advantage in terms of increased loyalty and productivity.
In order to establish an ESOP, a company must have been in business and shown a profit for at least three years. One of the main factors limiting the growth of ESOPs is that they are relatively complicated and require strict reporting, and thus can be quite expensive to establish and administer. According to Nation's Business, ESOP set up costs range from $20,000 to $50,000, and there may be additional fees involved if the company chooses to hire an outside administrator. For closely held corporations—whose stock is not publicly traded and thus does not have a readily discernable market value—federal law requires an independent evaluation of the ESOP each year, which may cost $10,000. On the plus side, many plan costs are tax deductible.
Employers can choose between two main types of ESOPs, loosely known as basic ESOPs and leveraged ESOPs. They differ primarily in the ways in which the ESOP obtains the company's stock. In a basic ESOP, the employer simply contributes securities or cash to the plan each year—like an ordinary profit-sharing plan—so that the ESOP can purchase stock. Such contributions are tax-deductible for the employer to a limit of 15 percent of payroll. In contrast, leveraged ESOPs obtain bank loans to purchase the company's stock. The employer can then use the proceeds of the stock purchase to expand the business, or to fund the business owner's retirement nest egg. The business can repay the loans through contributions to the ESOP that are tax-deductible for the employer to a limit of 25 percent of payroll.
An ESOP can also be a useful tool in facilitating the buying and selling of small businesses. For example, a business owner nearing retirement age can sell his or her stake in the company to the ESOP in order to gain tax advantages and provide for the continuation of the business. Some experts claim that transferring ownership to the employees in this way is preferable to third-party sales, which entail negative tax implications as well as the uncertainty of finding a buyer and collecting installment payments from them. Instead, the ESOP can borrow money to buy out the owner's stake in the company. If, after the stock purchase, the ESOP holds over 30 percent of the company's shares, then the owner can defer capital-gains taxes by investing the proceeds in a Qualified Replacement Property (QRP). QRPs can include stocks, bonds, and certain retirement accounts. The income stream generated by the QRP can help provide the business owner with income during retirement.
ESOPs can also prove helpful to those interested in buying a small business. Many individuals and companies choose to raise capital to finance such a purchase by selling nonvoting stock in the business to its employees. This strategy allows the purchaser to retain the voting shares in order to maintain control of the business. At one time, banks favored this sort of purchase arrangement because they were entitled to deduct 50 percent of the interest payments as long as the ESOP loan was used to purchase a majority stake in the company. However, this tax incentive for banks was eliminated with the passage of the Small Business Jobs Protection Act.
In addition to the various advantages that ESOPs can provide to business owners, sellers, and buyers, they also offer several benefits to employees. Like other types of retirement plans, the employer's contributions to an ESOP on behalf of employees are allowed to grow tax-free until the funds are distributed upon an employee's retirement. At the time an employee retires or leaves the company, he or she simply sells the stock back to the company. The proceeds of the stock sale can then be rolled over into another qualified retirement plan, like an Individual Retirement Account (IRA) or a plan sponsored by another employer. Another provision of ESOPs gives participants—upon reaching the age of 55 and putting in at least ten years of service—the option of diversifying their ESOP investment away from company stock and toward more traditional investments.
The financial rewards associated with ESOPs can be particularly impressive for long-term employees who have participated in the growth of a company. Of course, employees encounter some risks with ESOPs, too, since much of their retirement funds are invested in the stock of one small company. In fact, an ESOP may become worthless if the sponsoring company goes bankrupt. But history has shown that this scenario is unlikely to occur: only 1 percent of ESOP firms have gone under financially in the last 20 years.
WHO SHOULD ESTABLISH AN ESOP
Although 1996 legislation opened the door for S corporations to establish ESOPs, the plans continue to be much more attractive for C corporations. In general, ESOPs are likely to prove too costly for very small companies, those with high employee turnover, or those that rely heavily on contract workers. ESOPs might also be problematic for businesses that have uncertain cash flow, since companies are contractually obligated to repurchase stock from employees when they retire or leave the company. Finally, ESOPs are most appropriate for companies that are committed to allowing employees to participate in the management of the business. Otherwise, an ESOP might tend to create resentment among employees who become part-owners of the company and then are not treated in accordance with their status.