Pros and Cons of ESOPs (Part 2)

Establishing an ESOP offers numerous benefits to shareholders, the company, and employees. Shareholders wishing to sell their stock have a ready market. More importantly, ESOPs offer an effective exit strategy for a business owner by providing liquidity, tax advantages, and flexibility.

In our previous article, we explained how an employee stock ownership plan (ESOP) works.  In this article, we explore the advantages and disadvantages of ESOPs to companies and employees alike.

 

As an exit strategy

About two-thirds of ESOPs are established to provide a market for the shares of a departing owner. A ‘C’ corporation owner can defer paying capital gains taxes by selling 30 percent or more of qualified shares to an ESOP and reinvesting the proceeds into a qualified replacement property.

With an ESOP, owners of a business can slowly transition out of daily operations, sell all at once, or remain with the company in some capacity, ensuring succession and the preservation of their legacy. It also provides stability, to both the company and its employees, who have helped build the business.

Cash flow, debt & tax considerations

Employee stock plans can also facilitate company cash flow, raise capital, and finance debt. Contributions to an ESOP are tax deductible, up to 25 percent of total company payroll. Dividends paid to ESOP participants by C corporations are also tax deductible, with no limits. In addition, the cost of raising capital is lower, since an ESOP can purchase newly issued common stock in pre-tax dollars.

An ESOP’s unique ability to borrow money either from the company or on the company’s credit offers not only a tax advantage but enables debt financing at low cost. Company stock is used as collateral and the proceeds going into the corporation can be used for a variety of business purposes.

The company pays back the loan with pre-tax dollars to the ESOP, which, in turn, pays the lender. Both principal and interest are tax deductible to the company and interest payments are excluded from its contribution limit.

There are differences in how the Internal Revenue code applies to C and S corporations; the latter, S corporations, do not enjoy all of the tax advantages available to C corporations. However, S corporations owned by an ESOP pay no income tax on earnings attributable to ESOP shares.

Employees benefit, too—ESOPs give workers at all levels of a company the opportunity to build wealth and save for retirement. They pay no income tax on corporate contributions to their accounts until they receive a distribution, which comes when they either leave the company or retire. Taxes can be further deferred by rolling over the distribution into an individual retirement account (IRA) upon departure.

A Boost to Performance

Employees who have a stake in a company can be more motivated, have greater job satisfaction, and enjoy more job security than workers in a non-ESOP environment.

Numerous studies illustrate that ESOP companies perform well, and often better than their peers, with Rutgers University, the U.S. Department of Labor, and the National Center for Employee Ownership (NCEO) citing the advantages.

A 2017 NCEO research report found that ESOP companies not only tended to grow faster than their non-ESOP counterparts, but provided greater job stability. Similarly, the Department of Labor (DOL) reported that between 2000 and 2014, ESOPs with 100 or more participants outperformed 401(k) programs, averaging a 5.1 percent aggregate rate of return versus 4.5 percent for non-ESOP businesses.

Research from the NCEO based on DOL filings showed companies with ESOPS contributed more to these programs, on average, than to 401(k) plans, and ESOP participants have approximately 2.2 times as much in their accounts as participants in comparable non-ESOP companies with defined contribution plans.

Lastly, among workers aged 28 to 34 sampled in the 2017 NCEO study, employee-owners have 92 percent higher median household wealth, 33 percent higher income from wages, and 53 percent longer median job tenure relative to workers who are not participants in ESOPs.

Possible Downsides

Employee stock ownership plans, for all their benefits, do have some disadvantages. A third party may be willing to pay more for a company than the fair market value required by ESOP regulations during a sale, and another downside is the dilution of current shareholder stock as new shares are issued.

Additionally, ESOPs are complex undertakings and must vigilantly comply with written procedures and both Employee Retirement Income Security Act and Internal Revenue Service rules.

Running afoul of regulations can result in lawsuits and/or loss of the plan’s tax-qualified status.

Costs & expenses

The plans also can be costly to establish and manage. The requirement to repurchase shares from departing employees can be a major expense. PNC Bank notes that businesses with consistent and predictable earnings are better ESOP candidates because “they are well-positioned to service the transaction debt and future repurchase obligation requirements.”

Like all defined contribution plans, there is no guarantee of returns. The value of an employee’s account rises and falls with the company stock pricing. There is little, if any, diversification to spread risk. A corporate failure can wipe out retirement savings. To protect employees nearing retirement, current regulations allow those 55 years or older with at least 10 years of ESOP participation to have some of their account diversified into other securities.

Many employee-owned companies also offer a 401(k) to counter risk. Triple T Transport, Inc., of Lewis Center, OH, provides both. “The 401(k) is important for diversification, so employees don’t have all their eggs in one basket,” says Wade Amelung, Triple T’s chief financial officer.

Risk vs. Reward

Establishing an employee stock ownership plan may be a good choice for a business owner looking for an exit strategy that offers liquidity, flexibility, and tax advantages, while maintaining the legacy of the company he or she built.

Establishing an ESOP is shown to improve company performance, maintain job stability, and offer employees a tax-deferred opportunity to build wealth for retirement. But the advantages must be weighed against other considerations specific to each company and its owner. Any business considering the establishment of an ESOP should consult with an expert to determine the suitability of doing so, clearly outlining all the advantages and possible disadvantages.