The Rise of the ESOP – Top 5 reasons companies are choosing this ownership structure
What is an ESOP?
An ESOP is an abbreviation for an Employee Stock Ownership Plan. ESOPs have become a popular ownership structure for many companies, small and large, with tens of thousands of U.S. companies having taken advantage of this ownership structure over the last 40 years.
While ESOPs are typically designed for privately held companies, many well-known Fortune 100 companies like Walgreens, Microsoft, Amazon and Google have also adopted ESOPs.
How does an ESOP work?
In simplest form, an ESOP creates a trust that actually buys stock in an organization, becoming an owner of the company. An ESOP is similar to a profit-sharing retirement plan, where employees would realize benefits over time based on the success of the company. Shares are allocated to individual employee accounts based on their compensation levels and, in some cases, how long they have worked at the company.
Employees with allocated shares in the trust are not technically direct owners of the company stock but rather are the beneficial owners and thus do not have all of the same rights (voting, access, etc.) as direct owners. This allows current stockholders the benefit of maintaining control over the organization despite the loss of their ownership percentage.
What are the advantages of having an ESOP?
1. Tax benefits
The tax implications of establishing an ESOP are significant. First, it allows current owners a vehicle to sell their current stock and avoid capital gains. By avoiding the tax, that means more cash in the owners’ pocket.
There are also significant tax benefits to the company. For an S-corp that is 100% owned by an ESOP, there is no income tax. I will say that again, there is no income tax paid by an S-corp that is 100% owned by an ESOP. That’s a gamechanger. Again, more cash in the owners’ pockets in the long run.
C-corps also can take advantage of certain tax benefits. If a C-corp pays a dividend to “traditional” stockholders, those dividends are not tax deductible; however, if they make contributions of profits to the ESOPs, those contributions are tax deductible, saving the company significant tax dollars while still transferring that wealth to owners. Again, a win-win for employees and the company.
Additionally, if the ESOP holds the bank loan directly, the company can make tax-deductible contributions for the full principal and interest payments. Normally, only the interest portion of debt repayment is tax deductible. But if the ESOP is the debtholder, the company can make contributions to the ESOP to pay the monthly loan payments, which in the end makes the full principal and interest repayment deductible to the company.
In essence, you could instantly make that loan 25% cheaper. By retaining those tax dollars in the company, it gives the company flexibility to invest in other areas to further grow and increase profitability.
2. Transferring wealth to those who helped build the company
Many business owners will argue that the most important asset to their company is their employees. Some have come on board recently, but some have probably been with them from the very beginning. Owners want to fairly compensate their employees not only through payroll, but also through offering competitive benefits.
One of these benefits is an ESOP. Employees that are “key” employees will be transferred more ownership than the newer employees, assuming those key employees have higher compensation levels and have been with the company longer.
3. Employee motivation
Research has shown that when employees are motivated and engaged, they are much more productive. Think Peter Gibbons from the movie Office Space. When Peter was in his interview with “The Bobs,” he expressed the fact that if he works harder and the company he works for (Initec) makes more money, he doesn’t get another dime. Now, hopefully your employees don’t have this attitude, but unfortunately there are some folks out there that do.
Many times, companies devise compensation programs with the goal of motivating employees to think and act like an owner. But whether short or long term, these programs don’t perfectly achieve that goal. However, an ESOP does just that. As true owners of the business, ESOP participants have a changed perspective of their role, the company and its future, which can boost productivity and the bottom line.
There are a ton of studies out there (Northwestern, Rutgers, Wharton, Iowa), but in the end they all come to the same conclusion: ESOP companies have a higher return on assets, a higher total shareholder return and a higher employee retention rate compared to non-ESOP companies. Now, an ESOP cannot magically make a bad company good, but it can make any company better.
4. Exit strategy/business succession
When looking to exit the business, finding an appropriate buyer is not always easy. Selling their shares to an ESOP at once or over time can provide business owners flexibility in succession planning and peace of mind that their employees’ jobs will not be displaced due to a sale.
Often, a business owner feels a sense of loyalty and gratitude toward their employees and wishes to convey additional value to them. An ESOP arrangement is one way to preserve the company’s culture and what made it successful. Instead of selling to a competitor or strategic buyer, the employees as buyers in an ESOP can carry on the company’s operations without concern for restructurings and reorganizations that commonly follow company sales.
5. Liquidity and diversification
Few of us would consider investing 100% of our retirement funds in a single Fortune 500 company, so it would be right to consider the similar consequences that could arise when participating in an ESOP. The diversification issue can be addressed in two ways. Regulations pertaining to ESOPs require that such plans permit participants over age 55 and with 10 years of service to divert a portion of their account out of company stock.
Further, many ESOP sponsors do take the step of offering a 401(k) plan in addition to the ESOP. Most ESOPs are funded by company contributions and require no contributions from employees. Therefore, a parallel 401(k) plan provides employees a way to make their own contributions to fund their retirement, which take the form of the typical fund options rather than company stock.
Like any business decision, both sides of the equation need to be analyzed. There are some limitations to be aware of regarding ESOPs. First, the initial cost to establish an ESOP can be substantial, and also the annual cost of valuations, tax filings and recordkeeping are not cheap.
Additionally, if the seller is also the key management employee, capable successor management must be in place to help assure the leadership of the company is clear and the company will continue to thrive in the future.
There may also be some limitations on the tax benefit of the contributions to be aware of. First, of course the company needs to be profitable in order to generate the cash flow and take advantage of the tax breaks. Second, there are certain ratios of payroll to revenue that must be achieved in order to qualify for the tax-deductible contributions.
The accounting and reporting related to an ESOP-owned company can also be tricky. The biggest impact is to the balance sheet.
For example, even though the ESOP holds the debt, current accounting standards require the debt to also be reflected on the company financial statements. And what about contributions accrued to the ESOP at the end of the year used to pay the loan balance? If we have to record the loan on the company books in addition to accruing contributions to the ESOP, wouldn’t we be “double-counting” this on the balance sheet? Guidance under ASC 718-40 indicates that no accrued contribution is recorded except for contributions that are not to be applied to debt service in the current period.
The debt could also be structured as an indirect loan or two-step loan. In other words, the company borrows funds from another source and then makes a second loan to the ESOP. In this case, the credit relationship between the ESOP and the sponsor is not recorded as an asset or a liability.
Additionally, there is no payable to the ESOP for the accrued contribution or receivable from the ESOP for its requirement to return these funds to the sponsor for that year’s payment. To the extent the sponsor borrowed funds from another party to finance the event, that loan would be recorded, and any other accrued contribution to the ESOP to cover plan expenses or fund distributions would also be recorded.
OK, so going back to the loan being recorded on the company books, a frequently asked question is, “Where would the corresponding debit go?”. The answer is to a contra-equity account commonly called “ESOP Loan Contra Account” or “Unearned ESOP Shares.” This contra equity account is eliminated over time as the loan is paid down and the shares are moved from “unallocated” to “allocated.” The timing of this release can be tricky, because for GAAP, the shares are released when the employer commits to make the payment or release the shares rather than when the transaction actually occurs.
While most of the impact is to the balance sheet and statement of shareholders’ equity, we should also consider the impact to the income statement. This would relate mostly to determining total compensation cost, but it also extends to calculating Earnings Per Share (EPS).
For example, while shares held as collateral remain outstanding for determining share value and voting, only the shares allocated are considered outstanding for purposes of calculating of calculating EPS.
And of course, don’t forget about the footnotes. Generally, footnotes must describe:
- A description of the plan, including the method of releasing shares and a description of the employer’s securities held by the plan.
- A table showing the number of shares, including a breakdown of allocated, released and unallocated shares.
- A description of the ESOP loan, including terms, payment commitments and interest rate.
- The amount of compensation expense for the period and the method for measuring compensation expense.
Proper planning and knowledge are a must when determining whether an ESOP is a good option for your company. Understanding the positives, the negative, and the accounting implications of ESOPs at the earliest possible stage of planning for an ESOP will set you up to make a well-informed decision.
Let Wipfli help you meet the requirements of your ESOP. Click here to learn more.
Read more articles on ESOPs:
- ESOPs have an advantage during a recession
- ESOP lessons learned from Pizzella v. Vinoskey
- Top 4 reasons companies are choosing an ESOP
- How to develop employee-owners in an ESOP
- Is there a problem with your ESOP?
- Top reasons you need to know the value of your business
- Two ways to manage your ESOP during the pandemic