An ESOP is a retirement plan that is designed to provide employees with an ownership interest in the company for which they work, by investing primarily in stock options of said company/employer. ESOPs are unlike other retirement plans, which typically diversify their holdings by investing in a variety of assets. The ESOP is funded with tax-deductible contributions by the employer, which can be in the form of company stock, or in cash which is used to purchase company stock. An ESOP operates through a trust, under the direction of a trustee or other named fiduciary. To be an ESOP, the plan must be specifically designated as an ESOP in the plan document, and must comply with special ESOP requirements of the Internal Revenue Service (“IRS”).
An ESOP is a technique of corporate finance as well as an employee benefit plan. An ESOP can be used to finance ownership transition, raise new equity capital, refinance outstanding debt or acquire productive assets. ESOPs can also be used to increase cash flow by making plan contributions in stock, instead of cash. Since contributions to the ESOP are fully tax deductible, an employer can fund both the principal and the interest payments on an ESOP’s debt service with pre-tax dollars. Dividends on ESOP stock are tax deductible if they are applied to repay principal of the loan made to acquire the company stock on which the dividends were paid. Reducing loan principal with pre-tax contributions and dividends generates significant tax savings, which in turn increases the ESOP Company’s cash flow.
This favorable tax treatment means that ESOPs are effective vehicles for financing ownership transition. There is strong statistical evidence that employee ownership improves employee morale and productivity, and reduces turnover. Surveys conducted by The ESOP Association show that most Association members report improved employee morale and productivity from their ESOPs. A study by the National Center for Employee Ownership found that ESOP companies grew more than 5% a year faster than their non-ESOP counterparts, and that ESOP companies with “participative” management styles grew at a rate three to four times faster than traditionally managed ESOP companies. An article by University of Pennsylvania Professor Steven F. Freeman in 2007, summarized the extensive evidence on employee ownership and concluded that combining employee ownership with increased employee participation can generate “astounding” returns on investment, and it is now generally accepted that ESOPs, especially in participative managed companies, can improve a company’s productivity.
One of the most popular uses for an ESOP is to provide a ready market for some or all of the shares owned by shareholders in a closely held company. With an ESOP in place, a majority or controlling shareholder has an exit strategy when he or she is ready to retire. Likewise, an ESOP is often an attractive buyer for a minority shareholder in a closely held company. While the tax deferral is not available for an S corporation selling shareholder, ESOPs offer many advantages to S corporations (See Question 12). With an ESOP, a majority shareholder has the option of selling only a portion of his or her stock to increase personal liquidity while maintaining control of the company.
Yes. Although this is not common, it is not prohibited.
An ESOP is leveraged if it borrows money or uses credit to acquire shares of company stock. The loan may be from a bank or financial institution, or the selling shareholder may finance the transaction by taking back a note for part or all of the purchase price. ESOP loans are usually structured in two parts; an “outside” loan to the company, the proceeds of which are then re-loaned through an “inside” loan to the ESOP. The proceeds of the inside loan are then used to purchase company stock. In this two-loan structure, the outside loan is secured by assets of the sponsor company and, in some cases, a guarantee or asset pledge from the selling shareholder.
The inside loan is secured only by a pledge of the shares purchased by the ESOP. The two loans need not have the same repayment terms; the inside loan is often for a longer term, which allows the purchased shares to be allocated over a longer period (See Question 19). An ESOP is the only kind of employee benefit plan that can use the credit of the company or a selling shareholder to finance the purchase of company stock. For all other qualified employee benefit plans, this would be a prohibited transaction under the Employee Retirement Income Security Act of 1974 (“ERISA”), as amended (See Question 43). Most ESOPs used for ownership transition purposes are designed as leveraged ESOPs, although non-leveraged ESOPs can also be structured to provide significant benefits in connection with corporate acquisitions and divestitures.