An ESOP is funded with tax-deductible contributions by the employer, which can be in the form of company stock or in cash used to purchase company stock. An ESOP operates through a trust under the direction of a trustee or other named fiduciary.
To be an ESOP, the plan must be specifically designated as an ESOP in the plan document. It must also comply with special ESOP requirements of the Internal Revenue Service (IRS).
Learn more by viewing SES Advisors Introduction to ESOPs webinar (Registration required).
- The company has strong cash flow and a history of increasing sales and profits.
- The company has consistently been in a high federal income tax bracket.
- The company has substantial stockholder equity.
- The company has capable second-line management in place.
SES Advisors also offers an online tool to help you self-assess ESOP feasibility. Our qualifying questions may help you in deciding to take the next step.
The ESOP rollover permits a shareholder to sell stock to an ESOP and defer capital gains taxes. This option can also be used to obtain estate planning benefits.
With an ESOP, a majority shareholder has the option of selling all or only a portion of his or her stock to increase personal liquidity while maintaining control of the company.
Read more about ownership transition options.
Since contributions to the ESOP are fully tax deductible, an employer can fund both the principal and the interest payment on an ESOPs debt service with pre-tax dollars.
Dividends on ESOP stock are tax-deductible if they are applied to repay ESOP loan principal the proceeds of which were used to acquire the employer securities with respect to which the dividends were paid. Reducing loan principal with pre-tax contributions and dividends generates significant tax savings, which in turns increases the ESOP company’s cash flow.
There is strong statistical evidence that employee ownership improves employee morale and productivity and reduces turnover. Surveys conducted by The ESOP Association show that most Association members report improved employee morale and productivity due to their ESOPs. A study by the National Center for Employee Ownership (NCEO) during the 1980s found that ESOP companies grew more than 5% faster than their non-ESOP counterparts. Moreover, the study showed that ESOP companies with participative management styles grew at a rate three to four times faster than traditionally managed ESOP companies. The NCEO results have been replicated by a number of later studies, and it is now generally accepted that ESOPs especially in participatively managed companies can improve a company’s productivity.
Discover why SES Advisors is uniquely qualified to help organizations design, install and administer ESOPs.
So long as a participants account remains in the ESOP trust, the value of the account including the appreciation in stock value is not taxable to the employee.
Employees age 55 or older with 10 or more years of participation in the ESOP must be allowed to diversify a portion of their ESOP accounts.
ESOP financing permits the repayment of acquisition debt with pre-tax dollars. This favorable tax treatment means that ESOPs are effective vehicles for financing management buyouts.
The next step is a feasibility study to analyze the overall framework for the transaction. Among the issues the study should address:
- How much the company can afford to contribute to the ESOP each year
- Whether part of the contribution cost can be offset by eliminating other benefit programs
- How the ESOP will affect the companys earnings and cash flow
- How the transaction will be structured
- How it will be financed
If a leveraged ESOP is established, a loan must be secured to finance the stock purchase transaction. Financing an ESOP transaction can be difficult if the lender is not familiar with ESOPs. If the seller finances the purchase transaction, the companys costs will likely be reduced.
Once financing has been arranged, legal counsel should prepare the ESOP plan documents. An ESOP sponsor has many choices to make in designing a plan that will work well in its own corporate culture. For that reason, it is advisable to work with experienced ESOP counsel in designing the ESOP.
The next step is to negotiate a stock purchase agreement between the ESOP fiduciary and the selling shareholder(s). The stock purchase agreement sets forth the price and other terms and conditions under which the ESOP will purchase stock from the selling shareholder(s). As in any stock purchase transaction, the stock purchase agreement typically contains representations and warranties about the company’s assets, operations and financial condition.
The final step before closing the transaction is an opinion from an independent appraiser. This opinion is required under DOL proposed regulations, and provides the necessary assurance that the ESOP is not paying more than fair market value for the company stock it purchases. In some cases the appraiser will also be asked to give an opinion that the transaction as a whole is fair to the ESOP from a financial point of view.
SES Advisors offers services at every stage of the ESOP life cycle from assessing feasibilityto designing and installing a plan , providing ESOP legal services and helping in obtaining financing . You may also wish to review our webinar, ESOP Structure Case Studies: How to Meet Various Owner & Company Goals [link to ESOP Structure Case Studies: How to Meet Various Owner & Company Goals.mp4].
SES Advisors offers services and support for the entire ESOP life cycle helping to ensure that an ESOP stays on track.
SES Advisors Plan Administration services can help you to address a full range of reporting and compliance requirements.
Explore SES Advisors ESOP design and installation services and then contact us to learn more about how we can help you explore options for plan structure.
In addition, ESOP participants who are approaching retirement age must be given an opportunity to diversify their ESOP accounts. For shares acquired by an ESOP after December 31, 1986, the ESOP must provide any participant who has attained age 55 and completed 10 or more years of service of participation in the ESOP with an annual option to diversify 25 percent of his or her ESOP account into investments other than company stock for five years. In the sixth year, the participant must be given a one-time option to diversify up to 50 percent of his or her account.
At least three investment options must be offered within the ESOP to meet the diversification requirements. Alternatively, the ESOP may transfer assets to another qualified plan, or make a distribution directly to the participant to satisfy the diversification requirements.
SES Advisors ESOP administration services can help ensure that your ESOP addresses reporting and compliance requirements.
Usually, employer contributions to an ESOP are allocated among the participants’ accounts in the plan based on their compensation from the company during the plan year. However, the allocation can also be based on a combination of compensation and years of service with the company. The latter option is more complicated to administer because of IRS rules designed to prohibit discrimination in favor of the highly compensated.
There is a ceiling on the amount of annual compensation that can be recognized for determining participant allocations in ESOPs and other tax-qualified retirement plans. The ceiling is set at $220,000 for plan years beginning in 2006, with future adjustments based on cost of living increases.
For calendar 2006, an employee who is compensated at an annual rate of $350,000 will receive the same allocation within the ESOP as an employee who earns $220,000.
The Code also imposes limits on the maximum annual additions to a participants ESOP account. Annual additions consist of the participants allocated share of the companys contribution and any forfeitures. For 2006, the maximum annual addition is the lesser of $44,000 or 100% of a participants compensation from the employer. For leveraged ESOPs which satisfy a special nondiscrimination test, interest paid on the ESOP loan and forfeitures do not count as an annual addition. A leveraged ESOP may also use the fair market value of the company stock released from the expense account (See Section 19) to determine the maximum annual additions to participants accounts.
Get educated about ESOPs by reading articles featuring or written by SES Advisors experts.
Benefits may be distributed in a lump sum or in installments. If installment distributions are available, the minimum distribution period may not exceed five years.
Explore SES Advisors archived webinars to learn more about ESOPs. You may also want to read our case study about the have/have not issue and the repurchase obligation .
SES Advisors provides expertise and support at every stage of the ESOP life cycle .
SES Advisors provides expertise and support at every stage of the ESOP life cycle.
ERISA requires that plan fiduciaries act prudently and solely in the interest of plan participants. Three of the most important responsibilities of an ESOP fiduciary are:
- Securing a proper valuation of the stock;
- Assuring that the interests of plan participants are protected in ESOP transactions; and
- Approving all purchases and sales of ESOP stock.
SES Advisors provides expertise and support at every stage of the ESOP life cycle .
Costs are a function of the complexity of the transaction. If owners take the time to get a better understanding of ESOPs, initial costs can be reduced.
Ongoing ESOP administrative expenses are similar to most profit sharing plans, with the exception of the annual valuation update needed to value company stock held in the ESOP.
SES Advisors delivers ESOP administration services with a simple and transparent fee structure empowering you to achieve better results while saving time and money.
Most ESOPs used for ownership transition purposes are designed as leveraged ESOPs, although non-leveraged ESOPs can also be structured to provide significant tax benefits in connection with corporate acquisitions and divestitures.
Read more about SES Advisors ESOP financing services . You may also want to read our article, Leveraged ESOPs Provide Exit Opportunity, or view our webinar, Floor Price Protection in Second-Stage, Leveraged ESOP Transactions (registration required).
In order to qualify for the rollover:
- The ESOP must own at least 30 percent of the companys stock
- The proceeds must be reinvested in Qualified Replacement Property
- The stock sold to the ESOP must be common stock with the greatest voting power and dividend rights
- The stock sold to the ESOP must have been acquired as an investment and not in an employment-related transfer
- The seller must have owned the stock being sold for at least three years
- The company is not an S corporation
Other things to note about the tax-free ESOP rollover:
- The selling shareholder, any 25% or greater shareholder, and certain family members, are generally prohibited from receiving allocations of stock acquired through a tax-free ESOP rollover.
- A shareholder may elect to roll over all or any portion of the ESOP sale proceeds. The election must be filed with the selling shareholders federal income tax return.
- The company must agree to pay a penalty tax if the ESOP shares acquired through the rollover are sold or disposed of by the ESOP within three years after the date of sale.
Distributions from the ESOP are subject to taxation, but favorable tax treatment may apply to lump sum distributions in the form of company stock.
For distributions received prior to age 59-1/2, an additional 10 percent excise tax is generally imposed unless the distribution was made on or after the employees death, disability, or separation from service after attaining age 55. Deductible cash dividends paid to ESOP participants are not subject to the early distribution excise tax; this favorable treatment does not extend to S corporation distributions.
Eligible ESOP distributions may be rolled over into an IRA or another qualified plan, in which case income taxes will be deferred.
The DOL and IRS have issued guidance on the factors that must be taken into account when appraising a company, and who should do the valuation. Basically, a qualified appraiser must (i) hold himself/herself out to the public as an appraiser or perform appraisals on a regular basis, and be qualified to make appraisals of the type of property being appraised; and (ii) be independent with respect to the company and other parties to the ESOP transaction.
The credibility the IRS or DOL attaches to the appraisers conclusion of fair market value will be greatly influenced by their assessment of the expertise demonstrated by the individual or firm doing the appraisal. The same can be said for the independence of the appraiser. In order to satisfy the independence criteria, the valuation cannot be done by:
- The taxpayer who maintains the ESOP
- A party to the transaction in which the ESOP acquired the property
- An employee of the taxpayer who maintains the ESOP
- An individual or firm regularly used by the taxpayer maintaining the ESOP who does not perform a majority of his or her appraisals for entities other than the taxpayer maintaining the ESOP
Additional Resources: ESOP Industry Websites
SES Advisors is pleased to support our national and local ESOP trade associations as sponsors, board and committee members, speakers and chapter officers. If you would like to further research Employee Stock Ownership Plan (ESOPs), we encourage you to visit these helpful industry websites:
National Center for Employee Ownership (NCEO) is a private, nonprofit membership and research organization that serves as the leading source of accurate, unbiased information on ESOPs, equity compensation plans such as stock options, and ownership culture.
The ESOP Association represents the interests of all corporations that sponsor ESOPs providing advocacy and educational services on behalf of its members.
Vermont Employee Ownership Center is a statewide nonprofit whose mission is to promote and foster employee ownership in order to broaden capital ownership, deepen employee participation, retain jobs, increase living standards for working families and stabilize communities.
Ohio Employee Ownership Center is a nonprofit outreach center of Kent State University. It supports the development of business across Ohio and around the world by its efforts that are proven to save jobs, create wealth and grow the economy.
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