ESOPs

 An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that provides employees with an ownership interest in their company by investing primarily in employer stock.

An ESOP is a defined contribution plan funded with tax-deductible contributions by the employer, in the form of company stock or cash allocated to participant accounts. It operates through a trust under the direction of a trustee or other named fiduciary, who acts in the best interest of all participants. 

No.  An ESOP does not accept employee contributions.

Most ESOPs are established by private companies and share one or more of these qualities:  

• An employer looking for an exit strategy, but not wanting to sell to a competitor
• Organizations with strong, stable cash flow and high profitability
• In a high federal income tax bracket 
• Not heavily leveraged with substantial stockholder equity 
• Capable second-line management in place
• A desire to create a culture where employees feel like owners and are interested in the performance of the company

An ESOP doubles as a corporate finance tool as well as an employee benefit plan. Below are some of the unique benefits of an ESOP.

• Financial Leverage. An ESOP can be used to finance ownership transition, raise new equity capital, refinance outstanding debt, or acquire productive assets. ESOPs can also be used to increase cash flow by making plan contributions in stock instead of cash.
• Tax Savings for Employers. Since contributions to the ESOP are fully tax deductible, an employer can fund both the principal and the interest payments on an ESOP’s debt with pre-tax dollars.

Dividends on ESOP stock are tax deductible if they are applied to repay principal of the loan made to acquire the company stock. Reducing loan principal with pre-tax contributions and dividends generates significant tax savings, which in turn increases the ESOP company’s cash flow. This favorable tax treatment means that ESOPs are effective vehicles for financing ownership transition.

• Increased Employee Productivity and Retention. There is strong statistical evidence that employee ownership improves employee morale and productivity, and reduces turnover. In addition, a study by the National Center for Employee Ownership found that ESOP companies grew more than 5% a year faster than their non-ESOP counterparts.

An article by University of Pennsylvania Professor Steven F. Freeman concluded that combining employee ownership with increased employee participation can generate “astounding” returns on investment. It is now generally accepted that ESOPs, especially in participatively managed companies, can improve a company’s productivity.

Costs are a function of the complexity of the plan. If owners take the time to get a better understanding of ESOPs, initial costs are reduced.  Ongoing ESOP administration expenses are similar to most profit sharing plans, with the exception of the annual valuation update needed to value company stock held in the ESOP.

As with all tax-qualified retirement plans, ESOPs must comply with one of two minimum vesting schedules established by the IRS.

• Cliff Vesting. A plan participant must be 100 percent vested after three years, but doesn’t need to be vested at all before that time.
• Graded Vesting. A participant must become 20 percent vested after two years and the vested percentage must increase 20 percent annually thereafter until 100 percent vesting is reached after six years.

A vesting schedule which provides for more rapid vesting than these minimums is permitted. Participants must become fully vested when they reach normal retirement age.

Employer contributions to an ESOP are usually allocated in proportion to the participants’ compensation from the company during the plan year. However, the allocation can also be based on a combination of compensation and years of service with the company. The latter option is more complicated to administer because of IRS rules designed to prohibit discrimination in favor of highly compensated employees.

Yes. Just as a company can terminate a profit sharing plan, it can also terminate an ESOP. At termination, all participants must become 100 percent vested and their accounts in the plan distributed within a reasonable time. Benefit distributions from the ESOP are eligible to be rolled over into an IRA. ESOP distributions not rolled over are taxable, but may be eligible for special favorable tax treatment.

Valuations of company stock in the ESOP must be made by an independent appraiser annually, and any time the ESOP purchases company stock from the company or an employee, officer, director, or 10 percent or greater shareholder.

Not each year, although the IRS requires that recurring and substantial contributions be made in any ongoing plan to maintain its qualified status. In a leveraged ESOP, however, participating employers usually commit to contribute enough cash to service the ESOP loan debt. In some cases, companies make additional debt payments to accumulate cash in the ESOP as a hedge against years in which their cash flow may be restricted.

An ESOP is leveraged if it borrows money or uses credit to acquire shares of company stock. The loan may be from a bank or financial institution, or the selling shareholder may finance the transaction by taking back a note for part or all of the purchase price.  An ESOP is the only kind of employee benefit plan that can use the credit of the company or a selling shareholder to finance the purchase of company stock. For all other qualified employee benefit plans, this would be a prohibited transaction.

Because companies are required to repurchase the stock of departing participants, all privately held ESOP companies have repurchase liability for company stock held in the ESOP. This liability can grow, and it is important companies are aware of the amount and be prepared for it. For this reason, we recommend repurchase studies on a regular basis to monitor repurchase liability.

Many ESOPs “recycle” shares by distributing cash accumulated in the plan or contributed by the company to former participants, and then reallocating the company shares in the former participants’ accounts to the accounts of active participants. This approach maintains the ESOP’s percentage ownership of the company at a constant level.

A company’s repurchase liability is determined by a number of factors, including: the size of the annual contribution to the ESOP, changes in value of the stock, the vesting schedule, ages of the participants, number of participants, turnover rates, the proportion of stock and cash in the annual ESOP contribution, method of distribution and repurchase of the ESOP shares, and the diversification options of eligible participants.

By adding the industry’s leading ESOP firms to our team, FuturePlan has become one of the largest providers of ESOP services in the US. The growth of our ESOP practice allows us to fully serve employers sponsoring ESOPs with plan design, communication, ongoing administration and recordkeeping, compliance, repurchase obligation studies, and more.

You can call 866-929-2525, or click here to contact a member of our team.