Profile factors like the size, industry, and lifespan of a company determine the type of retirement plans appropriate for a company’s ownership and employee base. Some plans prove beneficial to employees and owners alike—especially owners who foresee a partial or complete exit from the company.
An employee stock ownership plan or ESOP Services is an employee benefit plan that is especially beneficial to owners of mid-sized, private companies who are seeking to exit the company. That being said, an ESOP adds value and incentives to the employee base, because they are able to own shares in the company itself upon retirement.
Though ESOPs have surface similarities to typical retirement benefit plans such as 401(k), they differ in many key ways. In this article we will discuss the basics of a typical Employee Stock Ownership Plan, why it may be utilized, and how to best implement an ESOP in your company.
- What Is An Employee Stock Ownership Plan?
- Why Implement An ESOP?
- What Makes An ESOP Different From Other Retirement Plans/Benefits?
- Why Should I Utilize An External ESOP Service?
- How Should I Choose An ESOP Service?
What Is An Employee Stock Ownership Plan?
An employee stock ownership plan (ESOP) is a method of employee participation in a privately owned company. In layman’s terms, an ESOP is a standalone trust fund made up of stock asset contributions from the employer. These stocks are distributed evenly amongst the employee base of a company upon their departure or retirement and taxed upon withdrawal.
Specifics of an ESOP structure can vary from company to company depending on size, industry, and type of ownership. For example, one company’s circumstances may lead it to contribute 75% of its stock assets to an ESOP fund while another might only contribute 15%.
It is important to note that the vast majority of ESOPs privately-owned companies – only about 10% of all ESOPs in the United States are in public companies. In the United States, ESOPs are regulated by the Employee Retirement Income Security Act (ERISA), which sets a minimum federal standard for investment plans in private industry.
Generally, ESOPs are funded in one of three ways. A company can either:
- Develop a trust fund into which it injects new shares of its own stock
- Contribute its own money to purchase existing shares
- Establish the ESOP as a borrowing plan in which the company makes cash contributions to enable loan repayment
Each of these options can prove advantageous depending on the specific nature and size of the company. For example, the contributions of a company employing the third option are tax-deductible.
It is essential that ESOPs maintain an egalitarian structure. Shares must be distributed equally among all employees, regardless of any given employee’s income or importance to the company.
Employees are rewarded their share of stock once they retire or leave the company, at which point they may sell their stock back to the company or on the stock market. Other avenues may be pursued, as well.
ESOPs are generally beneficial to both employees and employers. Though the quality of an ESOP depends on the strength and consistency of each company’s stock offerings, the plan itself can offer far stronger retirement/severance benefits to lower-income workers than a standard 401(k) plan.
In some cases, a company’s 401(k) plan works in tandem with its ESOP; employers match employee 401(k) contributions with equal contributions of their own stock. Because private companies are not mandated to provide retirement benefits, such plans aren’t necessarily common.
Why Implement ESOP Services?
ESOPs may not be the best call for every company. Companies that implement ESOP services commonly do so to either facilitate the creation of a vehicle for an owner’s retirement plan, monetize illiquid assets without selling the company, reduce corporate tax weight via deductible contributions, or further motivate an employee base by linking employee benefit to company performance.
Developing an ESOP can be beneficial for both owners and employees, but it must be thoughtfully executed to reap the most benefits. Let’s dive deeper into these main indicators for ESOP implementation:
- Exit Strategy: According to ESOP.org, “about two-thirds of ESOPs are utilized to provide a market for the shares of a departing owner(s)” of a generally successful, closely-held private company. Because the ESOP is separate from the company, the departing owner can arrange a buyout of their stocks on terms that favor all parties involved—owner, employees, and the business.
- Performance-Based Employee Benefits: For an employee, an ESOP can be a motivator to maintain high performance. Because the value of distributed company stock is naturally tied to the company’s performance, an ESOP can incentivize employees to maintain the drive that will lead to continuing success.
- Monetize Illiquid Stock Assets: By creating an ESOP, an owner can monetize a number of their illiquid stock assets without selling the whole company. Stocks that would otherwise incur a loss can be restructured into an ESOP framework.
- Reduced Tax Burden: With a tax-qualified ESOP services, contributions from the company to the trust are tax-deductible. However, ERISA standards dictate the limit for annual employer contributions to an ESOP.
What Makes an ESOP Different From Other Employee Plans?
The decision to implement an ESOP depends on the profile of the company, as with any other employee retirement/benefit plan. Size, sector, and other variables may dictate the retirement plans that make the most sense for an employer. All the same, ESOPs stand out from other retirement packages in a few key ways. Let’s first compare an ESOP plan with a more typical 401(k) plan.
ESOP plans are similar to 401(k) in that employer contributions are tax-deferred until employees receive their shares, meaning owners are taxed on withdrawal.
While 401(k) takes money out of every employee paycheck prior to taxation, an ESOP plan rewards an employee share upon completion of employment. An employer may consider these factor before adopting either policy:
- Risk: 401(k) plans to benefit from the consistency of the collection. A 401(k) can be roughly calculated by an employee’s pay rate and time of employment. On the other hand, an ESOP’s value relies on the strength of the company’s stock prices at the time of the employee’s departure.
An ESOP can be subject to market volatility, which can jeopardize or enrich an employee’s retirement assets. Regardless, the structure inherently becomes riskier over time.
- Maneuverability: Both ESOP services and 401(k) can be rolled over into an individual retirement account (IRA) without taxation or penalties.
However, both types of accounts incur a 10% early withdrawal penalty. While 401(k) can be activated at a standard federal minimum age, an ESOP is distributed on an individual basis upon employee retirement/departure. Other retirement plans such as the Roth 401(k) allow the employee to contribute already-taxed money to their account, which will never be taxed again. The same applies to a Roth IRA.
Depending on the size and ownership of a company, an ESOP may prove the most appropriate vehicle for employee retirement funds. If a company is confident about its longevity, structure, and market standing, an ESOP trust could be a strong option.
Why Should I Use an External ESOP Service?
Entrusting the ESOP creation process to an external agent can sound tedious, but advantages from hiring an outside entity can far outweigh disadvantages—especially for smaller private companies that lack the necessary expertise and capital.
When a company uses an external ESOP service, it transfers responsibility to a source with proven expertise. ESOP services analyze key factors of a company’s structure and overall health to best establish an ESOP trust that benefits all involved. Let’s break down the main reasons for using a third-party service:
- Proficiency: External ESOP trustees are experts in the field. Development of an ESOP trust is a complicated process that can have its own set of challenges. External trustees have the experience to recognize and address issues that may arise in an ESOP.
- Assumption of Liability: An external ESOP service assumes all legal responsibility for an ESOP, as dictated by ERISA. Because of that assumed legal burden, outside trustees are required to provide service that ensures total compliance with the Department of Labor guidelines.
- Objectivity: Perhaps the most important component. Because third-party ESOP services operate under ERISA standards, objectivity in practice is a strict requirement. External trustees can provide a balanced ESOP with a neutral approach, avoiding the conflicts of interest that might arise if an internal source is tasked with ESOP creation.
Moreover, external ESOP services can provide fiduciary insurance to protect against claims made against it. Internal services may not have such insurance, which can open a company to potential financial and legal ramifications if ERISA standards are breached.
How Should I Choose an ESOP Service?
In any business decision regarding third-party services, reputation is the strongest indicator of quality. An ESOP trustee’s success hinges on the reputation that it has built through previous client relationships.
Implementing an ESOP service is no small decision. ESOP creation is a daunting task: shared stock ownership must exist in a structure that can stand the test of time and clear any legal hurdles.
Creating a new ESOP framework can be the first step in developing a retirement plan that works for all involved, from employees to owners. The most ironclad and comprehensive ESOPs result when companies employ a trustee who is not only results-oriented but relationship-driven, as well.
Strategic Equity Group has the experience and customer-oriented approach necessary to develop an ESOP for your company. Let us help you determine if an ESOP is right for your company—contact us today for a complimentary in-person meeting to discuss your company’s ESOP objectives.