Many commercial real estate brokers have inquired about the use of employee stock ownership plans within their companies, particularly as they relate to succession planning. A major motivator for small business owners in establishing an ESOP is that it can be used to buy out an owner at the appropriate time. According to a recent National Center for Employee Ownership article, 7,000 companies have ESOPs covering about 13.5 million employees.
ESOPs can be set up in C and S corporations, but generally not in LLCs. LLCs don't qualify because LLC ownership involves membership interests rather than stock. Therefore, in most instances, an LLC must convert to a corporate organization before adopting an ESOP, although a recent IRS private letter ruling allowed an ESOP in a LLC.
What Is an ESOP?
An ESOP is an employee benefit plan. A company sets up a trust fund and contributes new shares of its stock or money to buy existing shares, or has the plan borrow money to buy shares. Company contributions to the trust are tax deductible within limits.
The company appoints an independent ESOP trustee, subject to a high fiduciary duty standard, who assures that the ESOP purchases shares at fair market value. The annual expenses to maintain the ESOP include such costs as the trustee and an annual valuation to determine updated ESOP share value for administration purposes.
Shares in the trust are placed in individual employee accounts and allocations to employees are made according to a formula, which is often based on compensation. The ownership of shares in the employee's account increases with the employee's tenure with the company, until they are vested at 100 percent ownership. The vesting schedule is generally three to six years, depending on the terms of the plan. At the time the contributions are made, the employees pay no tax on their value.
Ownership of shares provides certain rights to the employees. In private companies, employees must be able to vote their shares on major issues that require shareholder approval under state law. In public companies, employees, through their share ownership, have the right to vote on all issues.
When employees leave the company, they receive their stock, which the company then buys back from them at fair market value unless there is a public market for the shares. Employees pay current tax on the distribution, with accumulated gains taxed as capital gains. For C corporations, it is possible to roll over the stock into an individual retirement account or another retirement plan.
Why Use an ESOP?
Companies share ownership with employees as a way to attract and retain good employees. Various studies indicate that employee-owned firms perform better than non-employee-owned firms, since employees are able to participate in decisions affecting their work. In the largest study to date, employee ownership researchers Douglas Kruse and Joseph Biasi of Rutgers University found that ESOPs appear to increase sales per employee by about 2.3 to 2.4 percent per year.
In small businesses, such as independent brokerage firms, an ESOP can provide a buyout for the company owner. When no family member or colleague wants to take over a business, it can be difficult to find an outside buyer willing to pay a fair price for the business. Often employees, through an ESOP, can step in and buy out the owner.
And finally, ESOPs provide tax benefits to the corporation. Contributions of stock or cash used to repay an ESOP loan are all tax deductible. In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level nor in some states, and dividends are tax deductible.
As previously stated, LLCs don't qualify to set up ESOPs because LLC ownership involves membership interests rather than stock. That said, IRS Private Letter Ruling 201538021, dated September 18, 2015, allowed an LLC to adopt an ESOP after identifying necessary features of the LLC to support its decision. A private letter ruling can only be relied upon by the taxpayer requesting it and is fact-specific to that taxpayer. Therefore, if your company's structure is a LLC and you want to set up an ESOP, consult with your attorney about converting to a corporate structure or seeking a private letter ruling.
ESOPs are qualified retirement plans governed by the Internal Revenue Code and by the fiduciary and disclosure rules of the Employee Retirement Income Security Act, or ERISA, of l974. Therefore, if you're interested in adopting an ESOP, consult with an experienced ESOP attorney about specific requirements, set-up costs, and ongoing maintenance requirements and costs.