Pros and Cons of ESOPs (Part 1)
What you should know about tax savings, succession, and employee satisfaction
When it comes to saving for the future, a company’s defined contribution retirement plan, like a 401(k), can be a great benefit to employees and draw prime associates to an organization. A less commonly offered retirement benefit is an employee stock ownership plan (ESOP), which enables employees to have an ownership interest in their employer’s company, usually without a cost.
Statistics show ESOPs can be beneficial to both owners and employees, offering tax advantages and improved performance. The following is part one of two introductory articles on ESOPs—explaining how they work and outlining the advantages and disadvantages to companies and employees alike.
Not a New Concept
Congress paved the way for ESOPs in 1974 with passage of the Employee Retirement Income Security Act, designed to encourage capital expansion and economic equity among workers. Although ESOPs grew rapidly in the 1980s due to tax advantages passed by Congress, they later waned as further alterations repealed some tax incentives and imposed penalties to prevent abuses of plan provisions.
About 4 percent of private industry provides ESOPs; of these, less than 10 percent are public companies. The National Center for Employee Ownership estimates there are roughly 7,000 ESOPs in the United States, covering about 14 million employees.
How ESOPs Work
When creating an ESOP, a company establishes a trust and hires a trustee, which can be a bank, other financial institution, or the company’s upper management. The trustee has the fiduciary responsibility to manage the plan and its assets for the benefit of its participants.
The trust acquires some or all of the operating company’s stock at a fair market price based on a valuation from an independent appraiser, which must be performed annually for privately held companies. The company can contribute new stock to the ESOP or provide cash to buy existing shares. An ESOP can also purchase stock from the company or its shareholders with a loan (called a leveraged ESOP).
Triple T Transport, Inc., of Lewis Center, OH near Columbus, launched its ESOP in January 2011 with owner financing. As a leveraged ESOP, “the company makes contributions to the trust in order to service the debt,” notes Wade Amelung, Triple T’s chief financial officer. “Shares are held as collateral; as debt is paid down, the shares are allocated to employee accounts using a formula,” he explains.
Contributions to an ESOP are allocated in pre-tax dollars to employee accounts, usually based as a proportion of annual compensation. To prohibit discrimination in favor of highly compensated employees, the plan must cover a substantial percentage of lower-paid workers, and annual compensation is limited. In 2018, the limit is $275,000.
Participants & distributions
Generally, all employees 21 or older with at least one year of service are eligible to participate. Employee ESOP accounts become vested over time—usually 100 percent after three years of service (referred to as cliff vesting) or gradually increasing with each year of service over a six-year period.
Employees receive a distribution from their account when they leave the company, based on fair market value (for private companies) or current market price (for public companies) of the shares they own. The distribution can be in a lump sum or parceled out over a five-year period. If an employee leaves before being fully vested, the employee forfeits the nonvested amount, which is reallocated among remaining participants.
In our second article, we will explore the benefits of establishing an ESOP and the possible downsides.