In the past decade, employee stock ownership plans (ESOPs) have steadily been increasing in popularity as public knowledge increases and the traditional methods of exit strategy have faded away. Historically, it was commonplace for a company owner to pass on the ownership of their business to their child or another heir. But in recent years, younger generations either do not want to or cannot take on the mantle of the family business. This has led business owners to seek out alternative exit strategies that do not involve mergers or acquisitions, which is how ESOPs came to the forefront.
The benefits of adopting an ESOP are multi-pronged, being advantageous for both owners and employees. The following are five advantages to consider:
1. Increased Productivity
Most ESOPs we work with are in industries that recognize strong employee loyalty but low 401(k) participation. Because an ESOP gives employees a share of the company, individual employees will directly benefit from the success of a company and will feel a sense of ownership. This can lead to an increase in productivity and an overall performance improvement for companies with employee stock plans. When employees have a financial stake in the business, their overall morale and trust in the company may increase.
2. Alternate Exit Strategy for Aging Owners
As mentioned above, the tradition of passing down family businesses is currently not as common. Additionally, as COVID-19 slowed down merger and acquisition (M&A) activity, business owners looking to retire had fewer options. In setting up an ESOP, owners will not have to sell their company to a third party; they can trust that it will be owned by the employees. Their information can also remain private and not shared with prospective buyers.
Owners who choose to remain involved with a business for a period of time also have the option of contributing shares to an ESOP over time rather than all at once.
3. Tax Advantages
ESOP structures allows for multiple tax advantages. For C-corporations, contributions made to ESOPs are tax-deductible, and for S-corporations, the portioned owned by the ESOP is tax-exempt. Employees are not taxed on the contributions received. Similar to a standard retirement account, individual employees only have to pay tax on the ESOP when they ultimately withdraw the money after retiring. Additionally, stock contributions are tax-deductible as are contributions used to repay the ESOP loans.
4. Attracting Top Talent and Employee Retention
Frequently, employees who stay less than two years at a company will forfeit their shares. An employee that stays four years may receive 40 percent of their shares upon leaving. This vesting process, or period of time an employee must work with a company to be entitled to receive their share payout, motivates employees to stay with a company as long as possible to earn the highest payout if and when they decide to leave. Having an opportunity to have a share in a company can be an attractive bonus for top talent seeking new job opportunities, as it provides a secure retirement plan.
5. No Change in Governance
When an owner steps back from their business with an ESOP in place, they will not have to worry about the disruption typically caused by a change in governance. This allows the company to maintain relationships with long-term suppliers, distributors and clients while also keeping management on board. Having the consistency of employee ownership, without the changes typically associated with new ownership, can also enhance employee loyalty to the company.
Is an ESOP Right for Your Company?
Current trends suggest that employee stock plans will increase in popularity in the coming years, though owners should evaluate their financial goals, succession timeframe and employees' interest in ownership before making any decision. Read our article on, "Best Practices for Considering and Implementing ESOPs" for more considerations.
It is critical to consult with advisors who are knowledgeable about accounting, legal and administrative issues unique to ESOPs. For questions about establishing an ESOP, or the related accounting or tax ramifications of ESOPs, contact our DHG Assurance team at firstname.lastname@example.org.