These plans can reward employees and help owners prepare for an exit.

Employee Stock Ownership Plans, or ESOPs, are a popular way for business owners to transition the company’s ownership to its employees.
An ESOP is also a retirement plan that allows employees to get tax benefits that are not available in other buy-sell structures. An ESOP …

» lets employees participate in the company’s success

»  aligns employee and company goals

» allows the business owner to transition out of the company without finding a third-party buyer

How an ESOP Operates

An ESOP operates through a trust set up by the company that allows employees to use tax-deductible contributions from the company to purchase the company stock or the company can contribute new shares of stock on the employees’ behalf. The company stock is distributed
to individual employee accounts within the trust.

The contributions given to each employee are based on that employee’s salary, tenure and position in the company. Generally, all full-time employees over age 21 are eligible to participate in the plan, and contributions can vest over certain periods of time ranging from three to six years. Employees receive the vested portion of their accounts at either termination, disability, death or retirement.

Is an ESOP for You?

An ESOP may be a great fit for your company if you have some or all of the following characteristics:

1. You want to sell to employees. Selling company stock to employees gives an owner an exit strategy that allows employees to own the business on the owner’s exit.
2. You want to reward your employees.
3. You want to supplement the company’s 401(k) plan.
4. The company is profitable. If your company is profitable, an ESOP will be advantageous from a tax perspective, because the company will reduce its taxable earnings by the amount used to fund the ESOP. If your company is not profitable, an ESOP may not
   make sense.
5. You want the tax benefits. Contributions to an ESOP can be tax-deductible, and some shareholders may be eligible for a tax-free rollover of the sale proceeds. Additionally, the company may reduce corporate income tax and increase cash flow by issuing stock into the ESOP.

ESOPs do have limitations. They are complicated and have compliance obligations. You can only use an ESOP in C- or S-corporations, not partnerships or most professional corporations. Also, because private companies must repurchase a departing employee’s shares, companies may face a major future expense if several employees quit or retire at the same time. Finally, setting up an ESOP is expensive even for a simple plan.

ESOP First Steps

If you decide an ESOP may be a good option for your company, you will want
to consider the following steps:

1. Determine if the company has a need for an ESOP. Do the owners want to transition ownership to employees? Do employees want to eventually succeed the current owners in management roles?
2. Conduct a feasibility study and valuation. Work to determine the value of your company’s equity by either hiring
   a consultant or using internal resources. You will have to consider the financial impact of the required contributions you must make into the trust.
3. Hire an ESOP adviser. This adviser or attorney will draft the ESOP plan to be submitted to the IRS.
4. Obtain funding for the plan. The ESOP can fund the plan through company contributions, borrowed money or funds generated from other investments.
5. Develop a process to operate the plan. You must appoint a trustee to oversee the plan. The trustee doesn’t have to be a company employee. The trustee must communicate how the plan works to employees.

ESOP Alternatives

If an ESOP isn’t ideal for you, you can achieve your goals in other ways. If your goal is to incentivize employees, you can institute a profit-sharing plan, offer stock options or grant phantom stock. Alternatively, if your goal is to develop a succession plan, you can sell to key employees outside an ESOP, or you can sell to a third-party buyer when the time is right.

The Bottom Line

An ESOP can be the perfect exit strategy for your company. It creates a benefit for employees and a market for your company’s stock. An ESOP allows you to sell your business gradually, instead of exiting suddenly after selling to a third party. If you decide to establish an ESOP, you will need to hire a valuation expert, a trustee and an experienced attorney or consultant who can set up the ESOP in compliance with IRS rules and regulations.