The ESOP Advantage for S-Corporations - SES Advisors
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The ESOP Advantage for S-Corporations

Author: James Steiker

“WASHINGTON, D.C. (March 31, 2015) – New data compiled by EY’s Quantitative Economics and Statistics (QUEST) practice, shows that private employee stock ownership retirement plans (S corporation ESOPs) outperformed the S&P 500 Total Returns Index in terms of total return per participant by an impressively large margin (62%), net assets increased over 300%, and distributions to participants totaled nearly $30 billion from 2002 to 2012.”

The interesting question is: why?

One might expect a natural advantage from the tax benefits of the structure, where a 100-percent ESOP-owned S corporation ESOP does not pay directly or indirectly any current corporate income taxes, while the S&P 500 companies pay an effective rate of 20-25%. This would only explain a portion of the performance difference through. Something else may be afoot.

I think there are several potential explanations.

First, there is 30 years of data showing that employee owned companies outperform their conventional counterparts, particularly when combined with employee participation and involvement. Undoubtedly, 100-percent ESOP-owned S corporation ESOP companies are the most ESOP focused companies and the value add of employee ownership may be improving the performance of these companies.

Second, while the tax savings of the structure are important, I think the related savings of not needing to perform unnatural acts to avoid taxes is an important benefit. Many companies spend many dollars and take many non-economic actions to reduce their tax burdens. 100-percent ESOP-owned S corporation ESOPs, with the lack of need to plan around taxes, may simply be more efficient in addition to being less tax burdened.

Finally, I think one of the lessons of the Great Recession is that financial structures where the ultimate owners are further away from the places where their capital is being used create inefficiencies. There are many parties (investment bankers, brokers, CEOs, boards, etc.) between an investor and the deployment of their capital in an S&P 500 company, and little ability for an investor, even large investors, to oversee the use of the capital.

The “remedy” for this in large companies is for investors to “vote with their feed” and invest elsewhere. In an ESOP company, the investors are watching their capital at work every day. There are more eyes and less tolerance for the “nuisance charges” of running a company and therefore less likelihood of excessive executive pay or intermediaries taking fractions of pennies from every dollar.

There is a national conversation going on about “income inequality”. The issue will not be addressed by confiscating wealth from those who have to give to those who don’t, no matter what folk’s ideological beliefs are. This data shows that S Corporation ESOPs can effectively create wealth for ESOP participants and potentially do so more effectively than the “investment industry.”

The data validates our intuition about the advantages of local and sustainable employee ownership and is “proof of concept” about the public benefits of private S corporation ESOP ownership.

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