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Is an ESOP Right for You?

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Is an ESOP Right for You?

Business owners are increasingly turning to ESOPs as a corporate finance tool to provide for liquidity and succession. For the business owner, an ESOP is a way to create liquidity, preserve company independence, protect wealth, diversify assets, plan for an orderly and phased succession, and defer taxes. For employees, an ESOP is a company-funded retirement plan that offers an ownership stake in the company. For the company, an ESOP is a way to finance ownership transition in a tax-favored transaction. But what exactly is it?

What is an ESOP?

  • Employee Stock Ownership Plan (NOT a Stock Plan)
  • Tax-qualified retirement plan created as part of the Employee Retirement Security Income Security Act (ERISA) in 1974
  • Regulated by U.S. Department of Labor (DOL) and IRS
  • Usually a Company funded benefit – no employee contributions
  • Assets held in a Trust; employees do NOT own the stock directly
  • Tax efficient and controlled means of selling stock

There are more than 10,000 ESOP companies nationwide, covering more than 13 million employees (data provided by NCEO).

How is the ESOP Different from Other Retirement Plans?

ESOPs are similar to other retirement plans such as 401(k) and profit-sharing plans, but they have several distinguishing characteristics:

  1. Unlike other plans, which are required by law to diversify their assets, ESOPs are required to invest primarily in the stock of the employer company.
  2. Unlike other retirement plans that generally invest employer contributions when received, ESOPs can borrow money to fund the purchase of a block of employer stock and repay this debt with future contributions.

Therefore, ESOPs can be used by business owners to create an internal market to sell a block of company stock. The ESOP can purchase all or a portion of a companys stock in one or more transactions, depending on the goals of the shareholders. For business owners who want liquidity and diversification in stages, an ESOP may be an ideal approach.

Tax Advantage

The government provides special tax incentives to spur creation of ESOPs. For example, companies can fund the purchase of stock from shareholders using tax-deductible dollars. Shareholders generally can defer capital gains taxes on the sale of shares to an ESOP if the ESOP owns more than 30 percent of outstanding company shares, the company is or becomes a C corporation, and the selling shareholder uses the proceeds of the transaction to purchase stocks or bonds of any domestic operating corporation.

Unlike other S corporation shareholders, if an ESOP is a shareholder of a company that is or becomes an S corporation, the ESOP does not pay taxes on its share of the corporate income. A company which sponsors an ESOP that owns 100 percent of company stock is effectively tax-free because, as an S corporation, the company pays no corporate income tax, and the ESOP, as a tax-exempt shareholder pays no individual income tax on the corporations income.

How an ESOP Works

The first step in establishing an ESOP is to analyze your companys financial information, revisit your business plan, and determine what you want to accomplish with the ESOP. The goal of this feasibility analysis, accomplished with or without outside professional help, is an approximate valuation of the company and an ESOP transaction design that will meet your goals.

A typical leveraged ESOP transaction works like this:

  1. The company establishes an Employee Stock Ownership Trust.
  2. The Company borrows money from a bank, usually secured by a security interest in the companys assets.
  3. The Trust borrows this money from the company, secured by a pledge of the stock that it purchases with the money.
  4. The Trust uses the borrowed money to purchase all or a portion of the company stock from the stockholder.
  5. The bank may require the shareholder to pledge some of the money it receives as security for the banks loan to the company.


ESOP transactions are not name your own price. An ESOP must have an independent appraiser determine the fair market value of the shares of company stock to be purchased by the ESOP and cannot pay more than fair market value for the shares.

Is Your Company a Good ESOP Candidate?

  • Are you profitable and growing?
  • Can the company finance its own growth?
  • The company is not overleveraged
  • Do you have good financial reporting?
  • Do you have a deep and broad management team?
  • Are your employees an important part of the value of your business?
Structured properly, ESOPs provide business owners with both liquidity and succession at a controlled pace, while simultaneously creating an employee benefit based largely on the success of the business. ESOP companies generally outperform their non-ESOP counterparts, measured by productivity and profitability. Participation in an ESOP gives employees a piece of the action.
If you are looking for an exit strategy that offers fair value for your company ownership, doesnt require an immediate sale to a third party, and rewards the people who have helped build your business, consider an ESOP. It may be the right win-win strategy for the company, the shareholders and the employees.


Contact the Author
Alice Simons, Director of Marketing

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