With so much competition when it comes to retaining employees, business owners are always exploring innovative ways to align the interests of employees with the overall success of the business.
One such approach that has been around since 1956 is the Employee Stock Ownership Plan (ESOP).
This strategy allows employees to become partial owners of the company through stock ownership, fostering a sense of shared success and long-term commitment. However, like any business decision, implementing an ESOP comes with its own set of advantages and challenges. In this article, we will delve into the key aspects of ESOPs to help you determine whether this employee ownership model is the right fit for you and the exit of your business.
What Is An Employee Stock Ownership Plan?
An Employee Stock Ownership Program is a Qualified Retirement Plan where employees are granted or can purchase shares in the company for one or all of three purposes:
- Allowing employees to have partial stake in the company,
- Selling shares to diversify the owner’s investments, and getting liquidity or
- The business owner is considering their exit strategy
The primary goal with giving partial stake in the business is to create a sense of ownership and accountability among employees, as their financial well-being becomes directly tied to the company’s performance. The important point, when selling a partial or total stake in the business is the owner can maintain control of said business.
But, more often, the goal of establishing an ESOP is for the owner to consider an exit strategy. Selling a minority interest in a closely held business is easier to do with an ESOP because it creates a ready market for the owner’s shares, especially when there may not be one to acquire just a minority interest.
4 Pros of Implementing An Employee Stock Ownership Plan
#1 Increased Employee Engagement and Productivity
For employees who have a stake in the company they work for, they are often more engaged and motivated, naturally. The prospect of potential financial gains through stock ownership can lead to increased productivity and a stronger commitment to the organization’s success. And part of your succession plan should consider how you will build value prior to exiting your business.
#2 Retirement Benefits for Employees
ESOPs can serve as a retirement savings vehicle for employees, providing them with a valuable financial asset that grows over time.
Instead of relying solely on traditional retirement investments that are commonly found in 401(k)s, employees have the opportunity to accumulate wealth in the form of company stock, potentially enhancing the overall diversity of their investment holdings.
For example, if an ESOP owns 100 percent of the stock of an C corporation, neither the company NOR the company’s sole shareholder (the ESOP) currently pays any taxes on the business profits. Instead, taxes are paid by employees only when they cash in their retirement benefits from the ESOP or, if their retirement account is later rolled over into an Individual Retirement Account, when they cash out of that account. At that time, the retiree pays ordinary income tax on the value of the benefits paid from that IRA account.
This can be particularly attractive for businesses looking to enhance their employee benefits package.
#3 Succession Planning and Business Continuity
As you start to consider what your ultimate exit from your business will look like, an ESOP may be a strategic move when facing succession planning challenges. Succession planning comes with many steps (and sometimes hurdles) including:
- Identifying the value of your business
- Finding the right buyer
- Tax and legal considerations, and
- Key employee concerns
Because of these extensive steps, it’s ideal to start planning for the exit of your business 5 to 7 years before you plan to exit. Yes, 5 to 7 years, trust us.
With an ESOP option for your business, the due diligence necessary is still present but is far LESS complicated and LESS exhaustive. This may be because the buyer knows the business to a greater degree, or that the buyer is more motivated for the transaction to happen. The buyer being your employees in the ESOP.
When your buyer knows the business to a greater degree, this option provides a mechanism for existing owners to gradually exit the business while ensuring continuity and stability. Continuity of the business during this process and beyond is key for continued success.
#4 Tax Benefits for the Company
In certain cases, businesses that implement ESOPs may be eligible for tax advantages. Companies can potentially deduct the principal and interest on loans used to finance the ESOP, helping to offset the cost of implementing the program. Tax benefits may include:
- Tax deductions on the contributions
- Tax deferment for the contributions
- Deferment and potential elimination of capital gains, in some instances
All of this leads to eliminating the business’ taxable income.
Top 2 Challenges of Implementing An Employee Stock Ownership Plan
#1 Upfront Costs and Complexity
Establishing an ESOP is not for everyone and involves initial costs, including legal and valuation expenses. Moreover, the business must be able to sustain the ESOP service payment and costs. The process can also be complex, requiring careful planning and expert advice to ensure compliance with regulatory requirements.
#2 Potential for Financial Volatility
Since the value of company shares within an ESOP is tied to the company’s performance, this program is susceptible to financial volatility. Economic downturns or challenges specific to the industry (competitors, costs, etc.) can lead to fluctuations in the value of the shares, affecting both employee morale and confidence in the program and the overall financial health of the ESOP.
This is especially important when deciding if this option is RIGHT for your business, its employees, and goals.
Implement An Employee Stock Ownership Plan
When implemented properly, an ESOP might be a great option for the success and succession of your business. However, even with appealing benefits, including an opportunity for tax savings, an ESOP is not suitable for every business.
Businesses with unstable financials, a high turnover rate, or have low profitability may find it challenging to implement and sustain an ESOP successfully.
Implementing an ESOP can be a powerful tool for commitment among employees and for a better retirement. With that said, it’s crucial to carefully evaluate the specific needs and dynamics of your business before deciding if an ESOP is the right fit.
To understand how to best position your business for its ultimate sale, reach out to a professional at Consolidated Planning that can help you make an informed decision that aligns with your business goals and values.
2023-165705 Exp. 12/2025
Material discussed is meant for general informational purposes only and is not to be construed as tax, legal, or investment advice. Although the information has been gathered from sources believed to be reliable, please note that individual situations can vary. Therefore, the information should be relied upon only when coordinated with individual professional advice.
