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 an introductory article 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ESOPs grew rapidly in the 1980s due to tax advantages passed by Congress, they later waned as further alterations repealed some tax incentives and imposed penalties to prevent abuses of plan provisions.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.
Among the more visible or widely known in the food industry are several supermarket chains: Lakeland, FL-based Publix Super Markets Inc.; H.E. Butt Grocery Company (H-E-B) in San Antonio, TX; Brookshire Grocery Company in Tyler, TX; and K-VA-T Food Stores, Inc., headquartered in Abingdon, VA.
Publix is the largest and one of the oldest employee-owned companies in the United States. Way back in 1933 founder George Jenkins offered employees a $2-per-week raise to buy shares in the company, which later evolved into an ESOP. In the 85 years since, shareholders have enjoyed a substantial return on investment.
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).
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 an introductory article 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.
Among the more visible or widely known in the food industry are several supermarket chains: Lakeland, FL-based Publix Super Markets Inc.; H.E. Butt Grocery Company (H-E-B) in San Antonio, TX; Brookshire Grocery Company in Tyler, TX; and K-VA-T Food Stores, Inc., headquartered in Abingdon, VA.
Publix is the largest and one of the oldest employee-owned companies in the United States. Way back in 1933 founder George Jenkins offered employees a $2-per-week raise to buy shares in the company, which later evolved into an ESOP. In the 85 years since, shareholders have enjoyed a substantial return on investment.
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.
Why establish an ESOP?
Establishing an ESOP offers numerous benefits to shareholders, the company, and employees. Shareholders wishing to sell their stock have a ready market. More importantly, ESOPs offer an effective exit strategy for a business owner by providing liquidity, tax advantages, and flexibility.
As an exit strategy
About two-thirds of ESOPs are established to provide a market for the shares of a departing owner. A ‘C’ corporation owner can defer paying capital gains taxes by selling 30 percent or more of qualified shares to an ESOP and reinvesting the proceeds into a qualified replacement property.
Salad Savoy Corporation, headquartered in Salinas, CA, started actively seeking an exit solution in 2015 for its owners who wanted to retire. By 2017, just two years later, Salad Savoy was an employee-owned company.
Since its founding in 1984, the company has enjoyed “a consistent increase in business,” according to chief executive officer Seth Karm. The 1990s, in particular, were a time of major growth as Karm says, “the industry really started to pay attention to our corner of ‘Color, Taste & Nutrition’ in the mid-1990s.”
In recent years, the company’s product lineup has expanded. “We, both the employees and the owners, did not want to stop this arc of growth. The ESOP has given the company the means and the structure to continue growing into the future, while also allowing John and Marsha Moore to realize the fruits of their many years of hard work and sweat equity put into this tiny but mighty company.”
With an ESOP, owners of a business can slowly transition out of daily operations, sell all at once, or remain with the company in some capacity, ensuring succession and the preservation of their legacy. It also provides stability, to both the company and its employees, who have helped build the business.
As an incentive
Although Carol Jenkins Barnett, daughter of Publix founder George Jenkins, says her father never thought of selling Publix or going public, his vision was for all associates to have a stake, as they were on the front lines. He believed employees, like himself, should be active participants in the company, every day.
Legacy and control were important issues for the owner of Triple T Transport. “Rather than sell to a strategic partner, a similar business to ours, or a competitor, the owner wanted to do something for employees. He wanted to retain his legacy,” notes Amelung. “With an ESOP, you can retain some control over the business and maintain a relationship in the business you’re proud of.”
Cash flow, debt & tax considerations
Employee stock plans can also facilitate company cash flow, raise capital, and finance debt. Contributions to an ESOP are tax deductible, up to 25 percent of total company payroll. Dividends paid to ESOP participants by C corporations are also tax deductible, with no limits. In addition, the cost of raising capital is lower, since an ESOP can purchase newly issued common stock in pre-tax dollars.
An ESOP’s unique ability to borrow money either from the company or on the company’s credit offers not only a tax advantage but enables debt financing at low cost. Company stock is used as collateral and the proceeds going into the corporation can be used for a variety of business purposes.
The company pays back the loan with pre-tax dollars to the ESOP, which, in turn, pays the lender. Both principal and interest are tax deductible to the company and interest payments are excluded from its contribution limit.
There are differences in how the Internal Revenue code applies to C and S corporations; the latter, S corporations, do not enjoy all of the tax advantages available to C corporations. However, S corporations owned by an ESOP pay no income tax on earnings attributable to ESOP shares.
Employees benefit, too—ESOPs give workers at all levels of a company the opportunity to build wealth and save for retirement. They pay no income tax on corporate contributions to their accounts until they receive a distribution, which comes when they either leave the company or retire. Taxes can be further deferred by rolling over the distribution into an individual retirement account (IRA) upon departure.
A Boost to Performance
Employees who have a stake in a company can be more motivated, have greater job satisfaction, and enjoy more job security than workers in a non-ESOP environment.
“Having this new structure has allowed for clearer, more prominent roles to emerge within the company,” confirms Salad Savoy’s Karm, “with a noticeable shift in attitudes and responsibilities to reflect the changing nature of ‘the employee’ to ‘individual owner.’ It’s hard to deny the appeal of a vested interest in the future growth and profitability of the company.
“We have all risen to the occasion,” Karm continues, “and with the groundwork put in place before John and Marsha assumed their new roles, we are in prime shape to continue the steady growth we’ve enjoyed over the last decade.”
Numerous studies illustrate that ESOP companies perform well, and often better than their peers, with Rutgers University, the U.S. Department of Labor, and the National Center for Employee Ownership (NCEO) citing the advantages.
A 2017 NCEO research report found that ESOP companies not only tended to grow faster than their non-ESOP counterparts, but provided greater job stability. Similarly, the Department of Labor (DOL) reported that between 2000 and 2014, ESOPs with 100 or more participants outperformed 401(k) programs, averaging a 5.1 percent aggregate rate of return versus 4.5 percent for non-ESOP businesses.
Research from the NCEO based on DOL filings showed companies with ESOPS contributed more to these programs, on average, than to 401(k) plans, and ESOP participants have approximately 2.2 times as much in their accounts as participants in comparable non-ESOP companies with defined contribution plans.
Lastly, among workers aged 28 to 34 sampled in the 2017 NCEO study, employee-owners have 92 percent higher median household wealth, 33 percent higher income from wages, and 53 percent longer median job tenure relative to workers who are not participants in ESOPs.
Possible Downsides
Employee stock ownership plans, for all their benefits, do have some disadvantages. A third party may be willing to pay more for a company than the fair market value required by ESOP regulations during a sale, and another downside is the dilution of current shareholder stock as new shares are issued.
Additionally, ESOPs are complex undertakings and must vigilantly comply with written procedures and both Employee Retirement Income Security Act and Internal Revenue Service rules.
Running afoul of regulations can result in lawsuits and/or loss of the plan’s tax-qualified status.
Costs & expenses
The plans also can be costly to establish and manage. The requirement to repurchase shares from departing employees can be a major expense. PNC Bank notes that businesses with consistent and predictable earnings are better ESOP candidates because “they are well-positioned to service the transaction debt and future repurchase obligation requirements.”
Like all defined contribution plans, there is no guarantee of returns. The value of an employee’s account rises and falls with the company stock pricing. There is little, if any, diversification to spread risk. A corporate failure can wipe out retirement savings. To protect employees nearing retirement, current regulations allow those 55 years or older with at least 10 years of ESOP participation to have some of their account diversified into other securities.
Many employee-owned companies also offer a 401(k) to counter risk. Triple T Transport provides both. “The 401(k) is important for diversification, so employees don’t have all their eggs in one basket,” says Amelung.
Risk vs. Reward
Establishing an employee stock ownership plan may be a good choice for a business owner looking for an exit strategy that offers liquidity, flexibility, and tax advantages, while maintaining the legacy of the company he or she built.
Establishing an ESOP is shown to improve company performance, maintain job stability, and offer employees a tax-deferred opportunity to build wealth for retirement. But the advantages must be weighed against other considerations specific to each company and its owner. Any business considering the establishment of an ESOP should consult with an expert to determine the suitability of doing so, clearly outlining all the advantages and possible disadvantages.
