What is an ESOP? | Frequently Asked Questions

An ESOP (Employee Stock Ownership Plan) is an attractive way to access personal wealth trapped in the shares of a privately owned business and distribute the wealth among the employees who helped create that business. Shareholders exploring this liquidity option often have similar questions. Here we provide answers to the most frequently asked questions about ESOPs.

What is an ESOP?

Technically, an ESOP is a qualified, defined contribution employee benefit plan that invests primarily in the stock of the employer. Practically, however, it is a tax-advantaged way to sell all of a portion of your business.

Why sell to an ESOP?

1. An ESOP offers the most flexible liquidity strategy available to business owners, allowing them to specify and control the most important issues in the sale of their business.
2. An ESOP provides compelling tax advantages to both the company and the selling shareholder.
3. With an ESOP, the business owner can retain operating control of the business and/or can transition management at the desired time and pace.
4. The ownership that the employees gain is a gift funded primarily by the tax advantages of the ESOP.

What are ESOP tax incentives?

1. Shareholder.  Most third-party sales are structured as asset purchases, creating an effective blended tax rate to the seller of roughly 29%. An ESOP sale is always a stock sale, generating gains taxed at 20% for the entire purchase price. In some instances, however, the shareholder may be able to defer even the 20% capital gains tax by reinvesting proceeds in US stocks and bonds.
2. Company.  With an ESOP, a company can shield significant portions (if not all) of its earnings from taxes going forward. This can increase the debt service capacity of the company by up to 37.5%.

Review more detailed information about ESOP tax advantages to discover whether this structure may be appropriate for your business.

How are shares distributed to employees?

1. Allocation.  Eligible employees are allocated shares over a period of years. Typically, the number of shares each employee receives is a function of that employee’s wages. If the company’s payroll is $10,000,000 and an employee earns $100,000 annually, the employee will receive 1% of the shares allocated in that year.
2. Vesting.  The Pension Protection Act of 2006 revised vesting to provide for three-year cliff vesting (fully vested after 3 years but no vesting prior) or six-year graded vesting, which must start in Year 2 and vest not less than 20% per year until 100% is reached in Year 6.

How are ESOP participants paid out?

1. Retirement.  The shares in the retiring employee’s account are put to the company or the ESOP, meaning the company is required to repurchase the stock from the retiring employee. The value can be paid out over a time frame of up to six years.
2. Before retirement.  The company can provide for up to a five-year pause before the six-year payout begins. This delay discourages employees from leaving the company prematurely just to access the balance in their account.

How is the value of the company determined?

An ESOP is legally required to pay no more than “adequate consideration” for the shares, and a good-faith effort must be made to determine fair market value. An independent valuation expert must consider the following three methods:

1. Income approach  (including discounted cash-flow method and/or capitalized earnings method)
2. Market approach  (including the guideline company method of comparing similar publicly traded companies and/or market transactions)
3. Asset approach  (generally appropriate for asset-intensive companies, not often used in ESOP valuations)

ESOPs are complex financial transactions, and PCE tailors each ESOP to fit the specific needs of the client. PCE also offers a “dual track” approach that, in addition to the ESOP process, includes a sales strategy considering both financial and strategic buyers.

If an ESOP sounds to you like an appealing succession strategy, give PCE a call so we can look at how to help you achieve your goals. You can also visit our ESOP planning library for additional resources to help guide you through the ESOP planning process.