ESOP FAQs: Frequently Asked Questions Related to Employee Stock Ownership Plans

Employee ownership can be an attractive option for owners looking to sell their business while maintaining their legacy and protecting the wellbeing of employees. The following article answers common questions related to the creation, financing, valuation and tax benefits of employee stock ownership plans (ESOPs).

What is an ESOP?

An ESOP — employee stock ownership plan — is a tax-qualified, broad-based, workplace retirement plan (similar to a 401(k) plan), that allows current and future employees to receive beneficial ownership in the company over time, which grows tax-free until paid out. Unlike a 401(k) plan, however, employees typically are not required to contribute to the ESOP. To get the special tax treatment, ESOPs must invest primarily in employer securities. ESOPs are also subject to the Employee Retirement Income Security Act of 1974, as amended (ERISA), which sets out fiduciary obligations and other protections for plan participants. ERISA requires that the ESOP’s assets be held in a trust, which is a separate legal entity from the employer.

In addition to providing retirement benefits for employees, an ESOP can be used as an exit or liquidity vehicle for the owner(s) of the company and can provide tax benefits to both the company and the selling shareholders, as well as an additional retirement benefit for employees.

What is the difference between a leveraged ESOP and non-leveraged ESOP?

An ESOP can be either non-leveraged or leveraged. In a non-leveraged ESOP, shares or cash (which can later be used to purchase non-ESOP shares from the sellers) are contributed to the ESOP. Once contributed, the shares or cash is allocated to employees’ accounts based on their salary, tenure, or a combination of both. The company receives a tax deduction for the fair market value of the shares or the cash contributed to the plan, subject to limits.

An ESOP is the only tax-qualified retirement plan in the U.S. that can borrow money. This allows for a leveraged ESOP transaction. In a leveraged ESOP, shares of stock are purchased by the ESOP trust with a note from either the company or the selling shareholders. The shares purchased with the note are held as collateral for the loan in a suspense account within the ESOP. As the note is repaid, unencumbered shares are released to the employees’ ESOP accounts. The note repayment is tax-deductible, subject to limits. The shares in the employees’ ESOP accounts will typically be subject to vesting, similar to the ERISA vesting rules that apply to an employer’s contributions to a 401(k) plan. When an employee leaves the company, typically, the employee is paid for his or her shares, either in a lump sum or over several years.

In both scenarios, the employee is the beneficial owner of those shares (and thus receives benefits from the shares), whereas the ESOP trust legally owns the shares (so the ESOP trust counts as only one shareholder, regardless of the number of ESOP participants). The trustee has a fiduciary duty to protect the employees’ retirement benefit. The ESOP trustee does not insert themselves into the day-to-day operation of the business, nor do they typically sit on the board of directors. Instead, their role is to ensure that any corporate action taken is in the best interest of the employees.

ESOP vs 401(k): What is the difference?

The biggest difference between the two plans is the out-of-pocket cost to the employee. In a 401(k) plan, employees make pre- or post-tax salary deferrals, and employers may also contribute to the plan. Many ESOP-owned companies will retain the existing 401(k) plan and may or may not continue to make employer contributions after the ESOP has been set up. In an ESOP, cash or shares are allocated based on employees’ salary and/or tenure with the company. Thus, for most ESOPs, there is no cost to the employee. Typically, benefits paid from the ESOP to the participant will be taxed at ordinary income tax rates when those shares are bought back at retirement, death, or separation from the company (although in some cases special “net unrealized appreciation” tax treatment may be available).

Another significant difference relates to how the funds are invested. In an ESOP, plan assets must be primarily invested in company shares, whereas in a 401(k) plan, participants can usually self-direct the investment of their plan account across various asset classes. To offset this concentration of investment in company stock, employees who are age 55 or older with 10 years of participation in the ESOP can diversify into different asset classes up to 25% of their company stock account each year over a five-year period, which increases to 50% during the sixth and final year of the special ESOP diversification window period.

Finally, another difference between an ESOP and a 401(k) is that enrollment in an ESOP is automatic for all qualifying employees, whereas with a 401(k) plan, automatic enrollment is not a given and an employee must opt-in if automatic enrollment is not part of the plan. So enrolling in a 401(k) can require some effort on the part of the employee.

How is an ESOP created?

An ESOP is created when the shares of a company are sold (or contributed) to an ESOP trustee via a negotiated process that considers not only the agreed upon fair market value of the company, but other relevant deal terms such as financing, management incentive plans, board composition, ESOP benefit levels, and indemnity agreements.

In many cases, an advisor is hired to represent the seller(s) to manage the sales process from start to finish and to facilitate a successful sale. The advisor will first undertake an initial study that includes a modeling assignment to evaluate whether an ESOP is feasible. Once feasibility is determined and the decision is made to move forward, the advisor can assist with facilitating a capital raise for the transaction, entity restructuring, plan design, and the negotiation with the trustee team and sources of capital.

How is an ESOP financed?

One of the more pressing questions from business owners regarding ESOPs pertains to the consideration they will receive for selling their ownership in the company to the ESOP. How do they get cash out of this transaction? First, commercial banks that are familiar with the structure and process of an ESOP transaction are usually willing to lend to creditworthy companies to help facilitate the sale to an ESOP. Any remaining balance on the sale could be made up using alternative lenders or deeply subordinated seller financing. Alternative lenders, such as mezzanine providers, require a higher return than a senior lender and can be expensive. If a company does not wish to use mezzanine financing to fund the ESOP purchase, then the sellers can replace that tranche of capital with seller notes that include cash interest payments, warrants, or a combination of the two. Combined, they represent the market return for a subordinated debt provider.

Sellers often have the option to receive either higher cash interest payments or reduced cash interest payments with the overall rate of return made up with warrants. A warrant is a contractual financial instrument (similar to an option) that gives the holder the right to own future equity in the company. Interest payments from the ESOP to the seller note holder are taxed at ordinary income rates, whereas a warrant would be taxed at capital gains rates (the capital gains tax rates in the U.S. are lower than ordinary income rates as of the date of publication). High interest payments are also a potential drain on company cash flows. A warrant allows the seller to reduce the cash interest payment and make up the overall rate of return. A warrant also provides the seller with upside in exchange for a lower annual cash return on his or her subordinated seller notes. This is a win-win for both parties, as the lower cash pay preserves cash flow at the company while the warrant(s) allow for the seller(s) to participate in the future upside of the company and receive capital gains treatment when exercised. Warrants can also help bridge the valuation gap between buyer and seller when the company is growing fast.

Does the business owner have to sell all of the company to the ESOP?

An ESOP allows the business owner, or selling shareholder, to decide how much of the business to sell and the timeline for ownership transition. Sometimes, the owner will initially sell a minority interest then complete a second-stage transaction at a later date. The sales timeline is completely at the discretion of the selling shareholder. Often, the benefits of a 100%-owned ESOP are too appealing to forgo. In addition, as noted below, to take advantage of a 1042 tax-free rollover the owner must sell enough shares to meet the 30% ESOP ownership requirement.

Does selling to an ESOP create debt?

The ESOP usually borrows money to buy the company’s shares, which is then repaid over time using the company’s future earnings. This process is known as a leveraged ESOP. If a lender is involved, the transaction debt is typically incurred on the company’s side through a combination of senior and junior financing. Involving an external lender in an ESOP transaction, and having the company collateralize the loan, allows the business owner to get liquidity while protecting their own personal wealth. It is important to note that the employees have no personal obligations to repay ESOP debt in most ESOP transactions.

Does the business owner need to stay with the company after the ESOP transaction?

The answer to this depends on how critical the selling shareholders are to the day-to-day operation of the business. Like any M&A transaction, in an ESOP transaction, it is typically anticipated, and at times mandated by the trustee, that the existing management team will remain with the company for a specific duration after the transaction. If the company already possesses a capable management team to succeed retiring executives post-sale, the period during which these executives commit to stay with the company after the sale tends to be shorter. In the long run, there is no strict requirement for the selling shareholders to stay, but it can depend on various factors such as the selling shareholders’ personal goals, the company's needs, and the terms of the ESOP transaction. Some selling shareholders choose to stay on to provide continuity, assist with the transition, help with the company's growth, and to make sure they are fully supporting the company while their seller notes are being repaid. Other sellers may decide to exit the business entirely. Ultimately, it is a personal decision that should be carefully considered based on individual circumstances.

Can an ESOP-owned company be sold?

A company can be sold after establishing an ESOP, but there are considerations to keep in mind. The sale could be to an external party or through an additional transaction within the ESOP. Such sales often require approval from the ESOP trustee and might be subject to specific ESOP plan provisions or ERISA regulations. There is also a distinction between an asset sale and a stock sale. In a stock sale, the trustee makes the ultimate decision whether to sell the stock, whereas, in an asset sale, the law general requires pass-through voting to ESOP participants.

Selling the company after setting up an ESOP can impact the ESOP’s intended benefits to employees.

Is an ESOP required to disclose details of the company’s financials to its employees?

The ESOP is only required to disclose to ESOP participants minimal company financial information on an annual basis. Company financial information, such as income statements and balance sheets, are not required to be provided to ESOP participants. ESOP loan documents (for leveraged ESOPs) generally are not required to be disclosed to ESOP participants.

However, ERISA requires that ESOP participants receive a Summary Annual Report (SAR), which is a summary of the annual financial report (on Form 5500) that the plan must file with the U.S. Department of Labor. The SAR includes financial information about the plan but does not include detailed company financials.

Additionally, ESOP participants must receive periodic account statements, typically delivered on an annual basis. These statements provide important information such as the company’s current share price, the number of shares allocated to the participants, and their vested account balance. The share price reflects the company's financial performance and allows participants to track the value of their ESOP holdings. ESOPs typically conduct an annual valuation of company stock, unless circumstances require a more frequent valuation.

Do the employees or the trustee of an ESOP run the company?

No. While employees gain beneficial ownership of company stock through the ESOP, the company is usually governed by a board of directors and managed by appointed executives, as in any other corporate structure. The ESOP trustee’s role is as a shareholder, which can influence major company decisions, but day-to-day management and operational control generally remain with the company’s leadership.

How are ESOPs valued?

The company’s stock is valued every year by an independent, qualified valuation firm selected by the ESOP trustee. The valuation is used to assess the company’s annual share price and the value of each employee’s ESOP account. The company stock is valued at fair market value, which is the price a willing buyer would pay for the stock and a willing seller would accept for the stock, assuming both parties have reasonable knowledge of the related facts and are not under any undue pressure to buy or sell. In transactions that include a management incentive plan and/or warrants, the value of those benefits is typically tied to the annual valuation of the company’s common stock shares.

How does the value of the company compare when selling to an ESOP vs. another buyer?

An ESOP pays fair market value for the stock of the company, like any financial buyer (for example, in private equity transactions). A seller could receive less compensation by selling to the ESOP than by selling to a strategic buyer, but the seller should also consider the additional value that the tax savings of an ESOP sale generate. A sale to an ESOP can increase the after-tax proceeds to the selling shareholder, because the selling shareholders may, with certain restrictions, defer capital gains taxes of the sale proceeds through an IRC Section 1042 tax deferral. The company can also take tax deductions of up to 25% of payroll by making an ESOP contribution each year.

What is a 1042 rollover?

One tax benefit that is unique to business owners who decide to sell their shares to an ESOP is the ability to defer capital gains, with the possibility of deferring and then eliminating capital gains taxes. IRC Section 1042 states that if after the sale of an ESOP (1) the ESOP owns at least 30% of the stock in the company, (2) the company is a C corporation, and (3) the selling shareholder has owned the stock for at least three years, there is a mechanism whereby the selling shareholder can potentially defer their capital gains tax obligation indefinitely.

If the proceeds from the sale to the ESOP are reinvested into what is referred to as qualified replacement property and the property is held until the investor’s death, then the heirs receive a step-up in basis and pay no capital gains taxes on both the original principal and the market appreciation. Qualified replacement property consists of domestic stocks, bonds, and corporate floating rate notes (subject to certain rules).

The SECURE 2.0 Act of 2022 provides that for sales to ESOPs after December 31, 2027, the IRC Section 1042 benefit is also available to S corporations, but with a limit of 10% of the proceeds for purposes of determining the amount of the gain.

What tax benefits does an ESOP provide to the company?

There are numerous tax benefits associated with ESOPs. Most importantly, if the selling company is structured as an S corporation, the percentage owned by the ESOP is exempt from federal and most state income taxes (including an exemption from unrelated business income tax that otherwise would generally apply to tax-exempt employee benefit trusts). Thus, a 100% ESOP-owned S corporation does not pay federal income taxes, and in most states, it would not pay state income taxes. In essence, an S corporation owned 100% by an ESOP operates a for-profit business as a tax-exempt entity, which can provide a competitive advantage. For S corporations in which the ESOP owns a minority interest, the company can deduct contributions to the ESOP of up to 25% of eligible payroll, under IRC Section 404.

If the selling company is a C corporation, it may deduct contributions used to make principal payments on an ESOP loan, subject to the 25% of eligible payroll limitation. Unlike the case for an ESOP that is owned by an S corporation, any contributions used to pay interest on an ESOP loan are not included in the 25% limit. However, interest expenses could be limited under IRC Section 163(j), which limits the deductibility of interest expense to 30% of adjusted taxable income. A C corporation is allowed an additional deduction of up to 25% of eligible payroll for contributions made to any qualified plan, as long as it is not used to repay an ESOP loan. In addition, a C corporation may deduct dividends paid to the ESOP trust without regard to otherwise applicable contribution limits (subject to certain limitations). Outside of an ESOP, companies generally cannot deduct dividends.

If a company is structured as an S corporation, will it be able to take advantage of all the tax benefits?

If the selling company is an S corporation, it will be able to take advantage of the most significant company tax benefit of ESOPs, which is income tax exemption, at the federal level and in most states, for the portion of the company owned by the ESOP. The company can take a tax deduction for the annual contributions to the ESOP as a qualified retirement plan. S corporation distributions to the ESOP, however, are not tax deductible (dividend deductions apply only for C corporations and in certain conditions).

Moreover, for the selling shareholders to be able to elect IRC Section 1042 and defer capital gain taxes on the sale proceeds, current law requires the company to be a C corporation. However, an S corporation can convert to a C corporation prior to the transaction, but it must remain a C corporation for five tax filings before converting back to an S corporation.

For sales of S corporations to ESOPs that occur after December 31, 2027, owners will be able to take advantage of IRC Section 1042, but limited to 10% of the sale proceeds.

What are the non-tax benefits of an ESOP?

In addition to the tax benefits of an ESOP, what makes ESOPs an attractive strategic alternative sale opportunity are the benefits that span across all stakeholders. Below are examples for each stakeholder:

Seller Benefits

• Gain flexibility to sell all or any portion of the business
• Receive fair market value
• Retain operating control
• Preserve legacy as an independent company
• Reward management and employees who helped to grow the business

Company Benefits

• Tax-advantaged financing
• Ability to repay debt more quickly with enhanced cash flow
• Enhanced corporate culture
• Potential for productivity gains and reduced turnover

Employee Benefits

• Valuable retirement benefits
• Ability to participate in value they helped create
• Continued employment in a rewarding environment
• Management incentive plans for key employees

What types of businesses are a good fit for an ESOP?

ESOPs can be a good fit for various types of businesses, but they tend to be more successful under certain conditions. Here is a non-exhaustive list of characteristics that often make businesses well-suited for an ESOP:

• Profitable and financially stable (i.e., can reasonably anticipate cash flows and revenue): ESOPs are long-term commitments, and the company needs to have the financial resilience to repay the transaction debt and buy back the shares from departing employees.
• Company must be a C or S corporation prior to transaction: If the company is an LLC or a partnership it must incorporate before the transaction.
• Minimal existing debt or sufficient debt collateral. The ESOP implementation is typically a leveraged transaction; thus, the company will be in a better position to take on debt if it doesn’t already have outstanding debt.
• Successor management team: The selling shareholders that ran the company before the transaction tend to leave the company some time after the transaction; thus, it is important to have a strong management team in place that can take over without disruptions to the business operations.
• Openness to the concept of broad-based ownership: Companies with a culture of employee engagement and involvement tend to thrive under an ESOP. Employee ownership can boost morale and productivity when employees feel they have a stake in the success of the business.
• Minimum number of employees is usually 20-25: ESOPs are subject to the IRC 409(p) anti-abuse compliance test, which is meant to ensure that ESOPs are fair and broad-based retirement plans. When companies have fewer than 20 employees, it becomes more difficult to meet the compliance requirements.
• Minimum EBITDA should be approximately $2 million: Companies that have an EBITDA of $2 million or higher tend to be more financially stable and have more resources to cover the cost of ESOP implementation.
• Has been in business for several years: This is tied to the first bullet: companies that have been in business for several years tend to have more stable and mature business models, as well as more stable and predictable cash flows.

Almost any industry can benefit from an ESOP structure; however, there are a few in which ESOPs tend to be more popular, such as construction, government contracting, manufacturing, and architecture and engineering.

What is the difference between an ESOP and an Employee Ownership Trust (EOT) established in the United Kingdom?

An ESOP and an EOT are both true employee ownership models in that the company is sold to the employees through a trust for the benefit of the current and future employees of the firm. ESOPs are more common in the U.S., EOTs in the UK. The key difference between the U.K. EOT and the U.S. ESOP model is that in an ESOP, the employees receive beneficial shares in individual retirement accounts and when they leave the company or retire they receive payment from the company for the value of those shares. Under the EOT model, the employees do not receive actual shares; instead, the trustee of the EOT holds the shares for and on behalf of all employees in the company.