Creating ESOPs: 6 Essential Questions For Successful Employee Stock Ownership Plans
January 12, 2016
The Baby Boomer business owner has worked hard for a lifetime. The company is thriving. But retirement is in sight, and a big question looms: How do I convert a lifetime of hard work into a comfortable retirement income?
The answer varies in every situation, but for many closely held businesses, an employee stock ownership plan (ESOP) is worth exploring. It’s a path for obtaining liquidity on a tax-favored basis, retaining control of the business, and giving employees a very valuable benefit.
The essence of ESOPs
An ESOP is a qualified retirement plan into which the sponsoring employer creates a trust fund into which it contributes tax-deductible shares of stock or cash. ESOPs can also borrow money to buy new or existing shares, and the company makes cash contributions that go toward paying off the loan. In either case, an ESOP creates a market for the owner’s shares – basically, turning those shares into a liquid asset.
The “stock ownership” part of the term is somewhat of a misnomer, because in most instances the employees never actually own stock. Instead, shares accumulate in their accounts and when the employees leave the company, they receive cash distributions equal to the value of their shares.
ESOPs have been around for decades. Studies have proven that workplaces with ESOPs tend to be more productive, because employees truly have “skin in the game.” These workplaces are also employee-centered and devoted to the education required to turn workers into knowledgeable ESOP “owners.”
Six ESOP questions business owners need to ask
Although ESOPs have many advantages, businesses should proceed cautiously before establishing an ESOP. There are numerous legal and regulatory hurdles to consider, plus costs. Business owners should consider these questions before creating ESOPs:
- Am I willing to invest my employees’ retirement plan assets in closely held, non-marketable stock? Dollars that the company may have contributed to a 401(k) plan in the past may now be dedicated to the ESOP.
- Am I prepared to adhere to the stringent federal regulations governing ESOPs? Each ESOP is managed by trustee empowered to make the threshold decision of whether buying the shares is a good investment for the plan and its participants. The trustee must also seek out an independent valuation of the company stock in order to determine its fair-market value. Federal law bars trustees from buying shares at a price above fair market value.
- Is my company suited for an ESOP? A feasibility study will determine if the company has the financial resources to sustain and properly operate an ESOP. Suitability takes into account the company’s cash flow, its ability to take on debt, the parameters for compliance with IRS rules limiting the business’ maximum annual deductible contribution and the value of shares that can be allocated to individual accounts in one year, and the company’s obligation to repurchase employees’ shares when distributions are required.
- Can my business manage its repurchase obligation? Careful planning assures the company is equipped to buy back employees’ shares when they part ways. Businesses whose employees range in age have an advantage over those where workers clustered in age groups will cause significant exposure in a short stretch of years. Fortunately, the distribution rules are somewhat liberal, and companies usually have at least five years to make distributions.
- What’s the financial status of my company? Is it strong now and likely to succeed into the future? Never forget that the performance of ESOP shares determines employees’ retirement incomes. The trustee will want to see projections. The company should have a strong cash flow to generate the money to contribute to the ESOP.
- How will my employees react? ESOPs can be strong productivity motivators, but it’s incumbent on management to foster a culture where employees understand the benefit.
The decision to launch an ESOP can represent a tremendous opportunity for a closely held business. Done properly it can offer benefits all around, translating the business owner’s years of hard work into liquidity while rewarding hard-working, dedicated employees with a tangible stake in the success of the company.
Stephen R. Kern chairs the Employee Benefits Group at McNees Wallace & Nurick, regularly advising clients on a broad range of employee benefits and executive compensation issues.