Journey to an ESOP & Beyond

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How ESOPs Work

Own the Success You Help Create

Employee Stock Ownership Plans (ESOPs) are a widely adopted option for promoting employee ownership in the United States. Some studies estimate that ESOP companies raise sales, employment, and sales per employee by 2.4 percent annually over what would otherwise be expected. These numbers represent businesses across industries, including manufacturing, construction, and professional services. Companies that adopt ESOPs are often privately held, although some publicly traded companies use ESOPs.

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Who Funds an ESOP

The employer funds the ESOP with tax-deductible contributions to purchase company shares. It operates through a trust under the direction of a trustee or another named fiduciary. An ESOP must comply with the requirements set by the Internal Revenue Service (IRS).

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When Employees Receive ESOP Benefits

ESOP distributions are paid out when employees leave the company. This can be in a lump sum payment or in substantially equal annual payments over a period of not more than five years.

Employees meeting certain requirements for age and plan participation may choose to take limited distributions for diversification purposes before leaving the company. These diversification rights begin at age 55 for employees with 10 years or more of employment with the ESOP.

Participants not subject to required minimum distributions (RMDs) who receive ESOP distributions can choose a rollover to another qualified plan to defer taxation until the money is withdrawn in retirement.

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What is an ESOP

An ESOP is a unique tax-qualified employee retirement plan designed to provide eligible employees with company ownership interest by investing primarily in the employer's stock. It differs from other retirement plans, which diversify investments across various assets. Employees receive the value of their shares earned as a retirement plan distribution when they leave the company or reach specific age and service milestones.

An ESOP is a versatile, tax-advantaged tool for business transitions and corporate financing. It allows stakeholders in closely held companies to access their equity while retaining management responsibilities and influence. This enables owners to plan leadership succession and ensure a seamless transition.

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Where Employee Ownership Thrives

ESOPs are commonly found in various industries, particularly companies prioritizing employee engagement and retention.

Privately-Held Companies: Many private companies use ESOPs as a succession planning tool, allowing owners to transition their company to their employees rather than outside buyers.
S-Corporations: ESOPs are particularly advantageous for S-Corporations, as they are exempt from federal income taxes, leading to significant tax savings.
Middle-Market and Small Businesses: ESOPs are commonly used by small to mid-sized companies to retain talent and give employees an ownership stake in the business.
Industries: ESOPs are prevalent in various sectors, such as manufacturing, retail, construction, technology, and professional services.

ESOPs are a strategic tool for employee engagement, corporate finance, and succession planning, aligning employee interests with the company’s success.

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Why Companies Choose ESOPs

When evaluating your options for exiting or achieving liquidity from your business, you will face many choices. Although the most traditional method of selling a privately held company is a sale to an unrelated third party, business owners often seek to keep their business in the family or sell to management. However, not all family members have the desire or ability to take over, and management may not have the means to purchase it. In addition, an owner may seek out an ownership exit strategy that allows the owner to retain the legacy of the business, maintain the company within the local community, and permit the owner to stay involved following a change in ownership. ESOPs are an attractive alternative to other exit options, and they have widespread appeal as more companies recognize the unique and flexible benefits.

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How an ESOP Works

A company establishes an employee stock ownership (ESOP) trust and makes annual, tax-deductible contributions. Typically used for income tax liabilities, these funds are redirected to pay the selling owner for shares sold to the ESOP. Contributions may include pay-down debt, new or treasury stock, or cash to purchase shares.

ESOP participants earn shares of company stock over time without investing their own money. Typically, after one year of full-time service, participants begin the vesting process. Contributions accumulate in the ESOP until an employee quits, retires, or is terminated. The company must repurchase shares at fair market value, and distributions can be made in a lump sum or installments, either immediately or deferred.

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Journey to an
ESOP & Beyond

In the Journey to an ESOP & Beyond podcast,

Phillip Hayes and Jason Miller address

ESOPs from a business owner’s perspective.

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