About ESOP’s

Congress has provided generous tax incentives for employee stock ownership plans (ESOPs). The benefit of the tax incentive is offered to not only the employer, but also the employees; lenders of an ESOP; and shareholders selling the stock. Furthermore, the states have enacted laws that apply to ESOPs, thus further increasing the total incentives.

An ESOP is a qualified, defined contribution employee retirement plan designed to invest primarily in employer stock of a sponsoring company. A company establishes a trust fund with the aim to buy shares from existing shareholders (owners) or to issue new shares.

Alternatively, a company can also borrow money to allow employees to buy existing or new shares. The company provides the cash contributions to repay the loan that is tax deductible.

Employee ownership of stocks can be carried out in different ways. Employees can purchase the stock options directly, receive stock options from the company as a bonus, or obtain the options through a profit-sharing plan. Also, some employees take part in ESOP through worker cooperatives. Generally, shares are allocated to full-time employees over 21 years of age. The allocations are made on the basis of a pre-determined formula. Senior employees may have more right to the shares and
vesting can apply. The vesting schedule can be done gradually or over a period of three to six years.

ESOPs provide a number of benefits to the sellers, to the employees and to the company. Benefits to the seller include:

  1. Owners can sell all or a portion of stock over time at full “fair market value.”
  2. Defer and possibly avoid capital gains tax completely
  3. Owner can transfer the company on their timetable to family or key management.
  4. Financing can be easier and more efficient than obtaining conventional financing.
  5. Owners may be able to maintain an equity interest (through warrants) in the future value of the company.

Benefits to the employees:

  1. Employees enjoy an equity stake in the company.
  2. Employees realize enhanced retirement benefits at no cost to them.
  3. The company remains an important part of the community.
  4. The Plan creates an ownership culture among employees that typically increases productivity, loyalty, and satisfaction.

Benefits to the company:

  1. Cash contributions are tax deductible. A company can contribute cash and make deductions on a discretionary basis every year. The contributions can be used to increase ESOP cash reserve in the future or purchase shares from the current shareholders.
  2. Stock contributions are also deductible. A firm can improve cash flow by issuing new shares to the employees. However, this will result in dilution of the existing owners’ shares.
  3. The share of ownership by the ESOP is not taxed for S-Corporations. In the case of S-Corporations, no income tax is charged at the federal level and most states mirror federal law. For instance, if the ESOP holds 30 percent of the stock, no tax is charged on 30 percent of the income of the S-corporation. Note that the ESOP should get the required share of any distributions that are paid to the owners.
  4. C-corporations can obtain tax deferral. If the ESOP owns more than 30 percent of the shares in a company, the tax laws allow tax deferral on the sale proceeds. The amount saved can be reinvested in the company.
  5. Interest paid to lenders is tax deductible. Interest and, in most cases, principal paid to the lenders that have provided financing in a leveraged ESOP is tax deductible.
  6. Employees’ ESOP accounts are not taxed. Employees have to pay taxes only on the dividends paid to them. The distributions are usually taxed at a favorable rate. Also, the employees are allowed to roll over the distributions to a retirement plan such as 401(k) or IRA. Any gains accumulated over time are taxed as capital gains. A penalty may be incurred if the distributions are taken out of the account before retirement.

Keep in mind that there are certain limits and drawbacks regarding ESOP contributions. The laws regarding ESOP tax incentives are not applicable for partnerships and many other types of corporations. Only specific companies can benefit from the tax incentive offered for ESOPs.

As mentioned above, S-corporations and C-corporations are eligible for tax incentives for an ESOP. However, S-corporations have lower contribution limits and they cannot complete an ESOP “rollover”. Private companies are required to buy shares of employees that leave the company. This can become a major expense for the company.

Furthermore, the cost of establishing an ESOP is significant. Companies will have to incur about $40,000 for even the simplest of plans. The cost of the plan will be higher for large companies. Also, whenever any new shares are issued, it dilutes the shares of existing owners.

The management of the company must weigh the pros and cons of the ESOP before using it as a tax saving and exit strategy. ESOPs may be suitable for companies valued at more than five million, EBITDA of one million and at least 15 employees.

When implemented correctly, the tax savings for these companies can
amount to millions of dollars.

Rob  O'Neill



A husband and wife team that owned a regional fence contracting company was looking for an exit strategy but did not want to sell to outsiders. They also wanted to participate in future growth of the company, which was valued at 15 million dollars. The husband and wife are 100% shareholders. Upon setup of the ESOP, owners receive $450,000 at closing and take back a 10-year seller note of $14.55 million at a 4.0% interest rate (Life of loan interest = 3.1 million). Sellers will also receive 500,000 warrant in exchange for taking back subordinated notes. At the end of the 10-year period, warrants are estimated to be worth $3.7 million. In addition, as a 100% ESOP-owned S-Corp, all future profits will not be taxed from that point, resulting in tax savings of over $7 million.