Home Fairfield Column: A fresh take on employee stock ownership plans

Column: A fresh take on employee stock ownership plans

Like many employers, you may encourage employees to “buy in” to what your company is trying to accomplish.

With an employee stock ownership plan (ESOP), employee participants literally buy into the business through a retirement savings arrangement. Meanwhile, you can benefit from an extra-motivated workforce, potential tax breaks and a relatively smooth path to management succession. Of course, there are risks to consider.

Indeed, statistics show that many employers find that giving employees part ownership of their companies can boost performance. For example, more than three-quarters of respondents to the 23rd Annual Economic Performance Survey, released in 2014 by the Employee Ownership Foundation, said their ESOPs positively affected overall productivity. What’s more, 70% reported that revenue increased while 64% saw a jump in profitability.

When a business owner is ready to retire or otherwise depart the company, the plan can play a practical role, too. ESOPs create a ready market for company stock. So the business can make tax-deductible contributions to the ESOP to buy out a departing owner’s shares or have the ESOP borrow money to buy the shares.

To be truly ready to establish an ESOP, the current owners of a company’s stock must be willing to sell their shares. Assuming they are, the business will need to engage an independent appraiser to complete an unbiased valuation. This is key, as the Department of Labor has initiated legal action against fiduciaries that allowed their ESOPs to buy company stock at other than market value.

To implement the plan, a company typically establishes a trust fund and either:

  • contributes shares of stock or money to buy the stock (an “unleveraged” ESOP); or
  • borrows funds to initially buy the stock, and then contributes cash to the plan to enable it to repay the loan (a “leveraged” ESOP).

The shares in the trust are allocated to individual employees’ accounts, often using a formula based on their respective compensation. Most companies will work with an attorney to develop a formal plan document that states (among other things) the ESOP’s purpose, the way it will operate, and its eligibility and participation requirements.

An ESOP’s stock is often held in the name of a trustee, such as a bank or trust company. The trustee has fiduciary responsibility and must act in the best interests of the plan and its participants.

The company has to formally adopt the plan and submit plan documents to the IRS, along with Form 5309, “Application for Determination of Employee Stock Ownership Plan,” and Form 5300, “Application for Determination for Employee Benefit Plan.” The IRS reviews this information to determine whether the plan qualifies for the tax benefits.

It’s essential for an employer to effectively communicate plan information to participants. Doing so is not only required by law, but, without this information, the positive impact an ESOP can have on workers’ motivation and productivity may be diminished.

Among the biggest benefits of an ESOP is that contributions to qualified plans typically are tax-deductible for employers. But employer contributions to all defined contribution plans, including ESOPs, are generally limited to 25 percent of covered payroll. In addition, C corporations with leveraged ESOPs can deduct contributions used to pay interest on the loan. That is, the interest isn’t counted toward the 25 percent limit.

Dividends paid on ESOP stock passed through to employees or used to repay an ESOP loan, so long as they’re reasonable, may be tax-deductible for C corporations. Dividends voluntarily reinvested by employees in company stock in the ESOP also are usually deductible by the business. (Employees, however, should review the tax implications of dividends.)

In another potential benefit, shareholder(s) in some closely held C corporations can sell stock to the ESOP and defer federal income taxes on any gains from the sale, with several stipulations. One is that the ESOP must own at least 30 percent of the company’s stock immediately after the sale. In addition, the sellers must reinvest the proceeds (or an equivalent amount) in qualified replacement property securities of domestic operation corporations within a set period of time.

(An ESOP’s tax impact for other entity types varies. Ask your financial adviser for details.)

Employees don’t pay tax on stock allocated to their ESOP accounts until they receive distributions. But, as with most retirement plans, if they take a distribution before they turn 59½ (or 55, if they’ve terminated employment), they may have to pay taxes and penalties – unless they roll the proceeds into an IRA or a successor plan.

ESOPs have a number of compelling benefits, but they’re not for every organization. For starters, many partnerships and professional corporations are prohibited from implementing them. A company that does establish one will need to buy the shares of employees who leave, which can substantially affect cash flow. And the cost to establish an ESOP in the first place can easily run to five or six figures.

In addition, because ESOPs are a type of employee retirement plan, most must comply with the Employee Retirement Income Security Act. Among other requirements, most ESOPs must cover the full-time employees who meet the company’s stated age and service criteria. Typically, participants must be vested in their account shares within three to six years.

Ultimately, these plans tend to work best in companies that can maintain strong cash flow and generate a substantial amount of taxable income. Keeping sales and profits relatively stable is important as well.

An ESOP can be a good way to motivate your employees and fund their retirements, while also accessing the associated tax and succession planning benefits. But you’ll need to assemble a team of trusted internal voices and expert external advisors to determine whether one of these arrangements would benefit your organization.

Norm Grill, CPA, (N.Grill@GRILL1.com) is managing partner of Grill & Partners, LLC, (www.GRILL1.com) certified public accountants and advisors to closely held companies and high-net-worth individuals, with offices in Fairfield and Darien; phone 203-254-3880.


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