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ESOP 101: The What/Why/How

The following video provides an overview of the many benefits that ESOPs can provide to retiring owners and future employees.

Is an ESOP Right for Your Business?

We are frequently asked whether an ESOP is right for a particular business. As a business owner reaches retirement age, the question of how to protect his legacy while exiting the business comes to the fore of his or her mind. On the one hand, an owner can sell his or her business outright. But this involves the owner immediately giving away all that they have worked for and built. An ESOP may provide a better option. In an article featured in Forbes magazine, contributor Stuart Robertson suggested five questions that will assist business owners in deciding whether an employee stock ownership plan (ESOP) is right for their business.

  1. Does the company make enough money? For Robertson, an ESOP makes sense only if a company has at least 20 employees and more than $5 million in annual sales. This is because the set up costs and annual costs of running the plan can cost thousands of dollars. While the 20 employee / $5 million in sales figures are not absolute, Robinson uses these numbers as a way of highlighting the need to conduct research and/or studies before setting up an ESOP to ensure such a plan is financially feasible for the company. We suggest that net profit in the range of $1 million is a better barometer.

  2. Does the owner or owners want to retain some measure of control? In a straight sale of a business, the owner or owners sell their ownership interests outright and thus lose all ownership rights in one instant. But an ESOP can allow an owner’s interests to be purchased in stages over time. For an owner who has worked for years to build the business, this gradual transition allows the owner to ease into retirement. Indeed, in most ESOP transactions, the owners remain board members and executives for some time after the close of the transaction.

  3. Is the owner in a hurry to sell? If the business is profitable and the owner is in no hurry to sell (i.e., the owner has some money in reserves and is comfortable with the employees buying him or her out over a period of time), an ESOP may make sense. Conversely, if the owner is strapped for cash and requires immediate and full liquidity, an ESOP may not be a good choice.

  4. Is the owner concerned about his or her tax liability? An ESOP can provide significant tax benefits, including deductibility of contributions and the deferral of capital gain on a sale of C corporation stock if proceeds are reinvested in stock of U.S. operating companies.

  5. Does the owner believe in his or her employees? Companies with ESOPs generally have higher productivity levels and larger profits because employees are motivated to help the business succeed. Owners who do not trust their employees to work for the betterment of the company may not see the benefits of setting up an ESOP.

Contact a Knowledgeable ESOP Attorney

Whether you set up an ESOP for your business is a decision that can have a dramatic impact on the future of your business. Do not make this decision without consulting with us at ESOP Plus. We can help you evaluate whether an ESOP makes sense for your situation and, if it is, we can assist you in setting the plan up. Contact ESOP Plus today at (888)-840-6830.

How Do I Set Up an ESOP?

40 years ago, Employee Stock Ownership Plans (ESOP) were virtually unheard of 4. Today there are approximately 7,000 vibrant companies that have ESOPs in place, benefiting over 13 million employees. While there are many reasons why a private company may set up an ESOP, the decision process to set up an ESOP and actually setting up such a plan usually includes the same or similar steps:

Step One: Determine if the Owners and Senior Management of the Company are Agreeable

It may go without saying, but an ESOP must have the agreement and support of the business owners. The business owners must be interested in liquidity and diversification of their wealth, and importantly, interested in transitioning ownership of the company to valued employees. It is also helpful if senior management (the valued employees) supports the process.

Step Two: A Feasibility Study

If owners and management are on board, a feasibility study should be performed. The size and complexity of the business will dictate how formal of a study is necessary, but at a minimum, a ballpark estimate of value should be determined so that the owners can decide if they want to sell. Then, cash flow, payroll, and the potential repurchase obligation of the company should be examined to determine if the company can afford to fund the purchase from the current owners and meet the limitations and requirements of the Internal Revenue Code.

Step Three: Design the Plan and Structure the Transaction

Assuming that the plan is feasible and supported by the owners and management, the next step should be to design the Plan and transaction—i.e. the sale of company stock to the ESOP. A knowledgeable ESOP attorney will draft a plan that allocates the benefit to employees in a manner acceptable to management and the IRS. Further, the knowledgeable ESOP attorney will advise as to compliance with fiduciary standards in ESOP transactions. The transaction may include bank financing, seller financing, or a combination of the two. Your ESOP attorney will assist in preparing any and all documents to ensure a smooth transaction that meets the goals of the parties and the most recent regulatory guidance. .

Step Four: Trustee Engaged and Transaction Closed

To complete any transaction, the company must engage a trustee who will act solely in the interests of the beneficiaries of the ESOP. While an employee of the company may act as trustee, it is a best practice to engage an “outside” trustee. Once the ESOP has been adopted and the transaction has occurred, the business may return to an “internal” (employee) trustee. The trustee must obtain the guidance of an independent appraiser. That appraiser will determine whether the price to be paid by the ESOP is no more than fair market value and the transaction is fair to the participants from a financial point of view.

Step Five: Carrying Out the Plan

Post-transaction activities include submitting the ESOP plan to the IRS for a determination of qualification. Your ESOP attorney will assist in this process. And like other defined contribution plans (i.e. 401(k)s), annual 5500 reporting must be completed for the ESOP. If the stock sold to the ESOP is not publicly traded, that stock must be valued on an annual basis. Not to be lost in the shuffle, employees must be educated about the ESOP and encouraged to get involved.

Contact ESOP Plus

The process of creating and carrying out an ESOP does not need to be intimidating. We can help you understand ESOPs and help you evaluate whether an ESOP makes sense for your situation. We can also guide you through the setup process and ensure your plan meets with IRS approval. Contact the ESOP Plus team today at (888) 840-6830.