What is an ESOP?

It is important that clients considering selling their business consider all options available.  One option is to sell the company to employees.  This can be accomplished through an employee stock ownership plan (ESOP).  An ESOP is an ownership interest in a company held by the company's workforce. The ownership interest may be facilitated by the company as part of employees' remuneration or incentive compensation for work performed, or the company itself may be employee owned.  If you are interested in an ESOP you should discuss this with a qualified tax advisor.

An ESOPis a stock bonus plan, or a stock bonus plan combined with a money purchase plan, that:

• Is designed to invest primarily in "qualifying employer securities" under ERISA Section 407(d)(5) (29 U.S.C. § 1107(d)(5)) and Internal Revenue Code (Code) Sections 409(l) and 4975(e)(8) (26 U.S.C. §§ 409(l)and 4975(e)(8)(see Qualifying Employer Securities).
• Satisfies other specific requirements set out in ERISA and the Code, including the tax-qualification requirements of Code Section 401(a) (26 U.S.C. § 401(a)) see Practice Note, Requirements for Qualified Retirement Plans).

The ESOP is unique among tax-qualified plans in that it is potentially a dual-purpose vehicle that can also be used as a corporate finance vehicle.

Qualification Rules

An ESOP must meet the requirements generally applicable to all tax-qualified defined contribution plans.

The advantages of being characterized as an ESOP are fully available only if the plan meets the requirements of both ERISA and the IRS Code. Therefore, references in this post to an ESOP mean a plan that complies with the ESOP requirements of both statutes.  

The ESOP entity is formed to buy stock of the company on behalf of all employees that meet minimum criteria. Buying into the ESOP is entrance into 410k plan.  This is like a retirement plan.  The ESOP is a trust that owns the shares. An employee earns an interest over time in the ESOP.  The ESOP has some very good tax benefits.  If you as a seller have your business set up as a C corporation and you are selling to an ESOP you can roll the proceeds into a specific type of fund with tax deferred benefits.  

If the ESP is set up as an S corporation and makes $1 million in taxable income, it normally would pay $350,000 in taxes for example.  However, tax advisors I have worked with advice that this S corporation that is an ESOP would not own any taxes.  Thus, in this context of the sale of a business the ESOP could take out a loan to buy your business and be able to pay off the loan sooner that other buyers perhaps could.  The savings on taxes avoided allow a potential seller note or bank loan to sell back sooner.

Employees earn a portion of the ESOP by their salary divided into the total of all salaries. Shares are released to employees on slower schedule.  The schedule likely would not be tied to paying off bank loan. The ESOP would not want too  much value to employees too quickly.  The ESOP would want to save some value for future employees.

The ESOP must do valuation every year. The ESOP also has to complete projections of revenues and other financial expectations.  The ESOP has a trustee.  The managers of the company answer to the Trustee (which is a third party) and employees based on projections and earnings. 

There can be quite a few expenses in the first year (perhaps $100,000 on administrative, then $25,000 year after that.  This kind of sale of a business to an ESOP is not going to work for an already leveraged company.  A long standing company (perhaps a service business with $7 million or more in revenues) without outstanding loans can do this.  The business generally needs to have at least fifty employees or more, thirty employees likely is not enough.

Please reach out to the Goosmann Law Firm if you are the potential buyer or seller of a business.  We are happy to connect you with a reputable tax and financial advisor.  We can help with the loan and purchase agreement documents.  We are committed to customer service and will consider alternative fee arrangements.

Angela Madathil is a Real Estate, M&A, and Deal Attorney and provides legal assistance to buyers and sellers of businesses, as well as business brokers in Kansas, Missouri, and Nebraska.   This can involve contract review and negotiation, due diligence assistance, and post-sale integration.  The Goosmann Law Firm team advises to buyers and sellers of businesses, as well as business brokers throughout the Midwest and has attorneys licensed in Iowa, Kansas, Minnesota, Missouri, Nebraska, South Dakota, and other states.