Defining ESOP and what it can be
While structuring and implementing ESOPs can be a very complex undertaking, the core definition of what they are is really quite simple. ESOP is an acronym for Employee Stock Ownership Plan – which is used to provide employees of a company with a retirement benefit through a plan whose value is based upon the financial performance of the company. ESOPs are required to follow regulations issued by both the IRS and the US Department of Labor, and the tax advantages of an ESOP make it a lower-cost source of corporate financing than conventional sources.
According to the National Center for Employee Ownership, ESOPs were first authorized under legislation that was passed in 1974. While the laws governing ESOPs have changed over the years, they generally provide incentives for selling owners and companies to encourage the implementation of the ESOP structure. Less than 40 years later, more than 11,000 companies have these plans in place, benefiting roughly 13 million employees. Today it’s the most common method of providing ownership to employees.
The purpose of the ESOP and why it’s unique
ESOPs are seldom used successfully to save troubled companies. Instead, they’re used to motivate and reward workers, to take advantage of financial incentives encouraging investment in new assets and to provide a market for the shares of departing owners of successful companies.
An ESOP is unique in that it’s technically an employee benefit retirement plan and acts as the facilitator of a tax-advantaged management buyout. This means the tax benefits of the structure significantly enhance the cash flow available to service debt and support growth. With a 100% S-Corp ESOP structure, the company is exempt from Federal income taxes, a major benefit of the structure. From a company and employees perspective, it’s a win-win situation and one of the true hallmarks of the structure. ESOPs are equity-based compensation and employees acquire the shares and vest in their accounts over a period of time.
There certainly are different paths for execution depending upon the exact nuances of the ESOP, but the following process is very common:
A company sets up a trust and contributes either new shares of stock or funds to buy existing or newly issued shares. Under the most common scenario, the company borrows money from a lender (the outside loan) and those funds are loaned to the trust (the inside loan) to provide it with funds to acquire the shares. The shares are then allocated to the employee accounts as the inside loan is repaid. Employees vest in the value of their accounts over time, with the vesting requirements the same as those of any other qualified ERISA plan.
Because the contributions the company makes to the trust to allow it to service the inside loan are tax-deductible as contributions to a qualified employee benefit plan, the company is able to repay a portion of the outside loan with pre-tax dollars. This doesn’t make any difference with a 100% S-Corp structure, but it’s an important advantage of the structure with a less than 100% S-Corp structure or a C-Corp ESOP. When an employee leaves the company, there are various requirements as to how the company must redeem the value of the employee account.
ESOPs are very complex. It takes significant expertise and multi-disciplinary knowledge to understand the structure and to optimize it. ESOP experts do, however, exist, and the professionals at Butcher Joseph Hayes are exactly that. We have seen nearly every iteration of an ESOP structure – and trust us, there are a lot – and know how to design and implement ESOPs to meet shareholder requirements and objectives. Here are just a few examples:
- Private equity firm exiting a portfolio company using an ESOP
- Family-owned private company transitioning into an ESOP for succession planning, wealth diversification or retirement
- Using our mezzanine/subordinated debt investment capability to support the recapitalization of ESOP-owned company
- Using our private equity expertise to support the buyout of an ESOP
We’re experts at managing risk and maximizing shareholder return and would appreciate the opportunity to discuss how our expertise can help you accomplish your objectives.