February 22, 2024
By: Brendan Hobbs and David Ottinger
What is an ESOP?
An “ESOP,” or Employee Stock Ownership Plan, similar to a 401(k) plan, is a type of tax-qualified employee benefit plan, meaning a sponsoring employer can make tax-deductible contributions to the plan on behalf of its employees. However, unlike 401(k) plans, which typically offer a range of investment options (for example: mutual funds, stocks, bonds, etc.), ESOPs are designed to primarily invest in the stock of the employer, thereby giving employees an ownership stake in the company they work for. Over time, employees have shares of company stock allocated to their personal accounts within the plan (typically based on factors such as salary or years of service). As the company’s value increases, so does the value of the employees’ accounts.
However, the establishment of an ESOP also financially benefits business owners. After all, in the vast majority of companies where an ESOP is established, the business owner does not donate his or her stock, but rather sells it to a trust (the "ESOP Trust"); this trust is established and maintained for the benefit of the employee participants under the plan. Assuming it is not publicly traded, the company will employ independent valuation experts to establish fair market value for the company stock. So long as the stock is not sold to the ESOP Trust at a price higher than its fair market value, the transaction should generally receive a green light from the U.S. Department of Labor, one of the two federal regulatory bodies that oversees ESOPs (the other being the Internal Revenue Service).
How do ESOPs benefit business owners and employees?
Business owners and employees alike stand to gain from establishing an ESOP.
Business owners, many of whom started their companies from the ground up, understandably want to see the fruits of their labor. ESOPs allow business owners to take advantage of the financial value they were able to generate through their company without having to turn it over to the hands of a stranger and risk destroying the legacy they worked hard to build and preserve (or worse yet, the company must close its doors upon the owner’s retirement with no buyer in sight).
The employees, many of whom helped build the company into what it is today, get to participate in its future growth and appreciation. It is not uncommon to hear stories of employees who would otherwise have very little in retirement savings ending up with ESOP account balances worth hundreds of thousands of dollars.
From a sustainability standpoint, the company benefits, too, as ESOP-owned companies often have cultures where everyone is invested from top to bottom. Furthermore, because ESOP Trusts are tax-exempt entities, an S-corporation owned by an ESOP Trust pays $0 in federal income tax. These tax savings often fund the debt obligations generated by the ESOP transaction.
ESOPs are growing in popularity as a business succession option
Given all the significant benefits ESOPs provide, it is no wonder that hundreds of business owners each year are turning to ESOPs as a business succession plan. According to NCEO, there have been nearly 7,000 ESOPs established nationwide, with roughly 10 million active participants. At GrayRobinson, our attorneys have taken part in establishing and maintaining nearly 70 ESOPs in 16 states across the country and have also represented numerous independent trustees in their fiduciary capacities during and after the purchase of company stock by an ESOP.
The bottom line
Although ESOPs often provide great financial benefits to business owners, employees, and the sponsoring companies themselves, they are subject to complex legal and regulatory requirements under the Internal Revenue Code and the Employee Retirement Income Security Act. Moreover, ESOP transactions often have complicated structuring issues which require legal acumen relating to state-specific corporate laws and tax-free reorganizations. The attorneys on GrayRobinson’s ESOP team are well-versed in these areas of law and can assist with navigating such complexities while also designing and structuring a plan to align with a company’s goals and objectives.
Questions?
Contact GrayRobinson Attorneys Brendan Hobbs, David Ottinger, or a member of the Business Law Section.