Transferring business ownership is an emotional process, particularly when one’s family members have no interest in taking the reins. It’s not easy to sell the business to an unknown outside party who may not be as invested in its history and culture.
You could sell the business to an employee, but what if no single employee is interested or can finance ownership? Another option for some businesses is to sell ownership not just to one employee, but to all of them.
What is an ESOP?
An employee stock ownership plan (ESOP) is an employee-owner program that provides the company’s workforce with an ownership interest in the business. An ESOP is achieved in a number of ways:
- Employees can buy stock directly
- Employees are given stock as a bonus
- Employees can receive stock options
- Employees receive stock through a profit sharing plan
According to the National Center for Employee Ownership, there are 6,717 ESOPs in the U.S. as of 2014, which cover over 14 million participants. ESOPs are subject to rules laid out by the Employee Retirement Income Security Act of 1974 (ERISA).
An ESOP can provide a market for the shares of a departing owner or owners, motivate and reward employees, or take advantage of incentives to borrow money for acquiring new assets in pre-tax dollars.
ESOP benefits and risks
One of the greatest benefits an ESOP could potentially provide is in taxes. Contributions of stock and cash contributions are deductible. Dividends and contributions used to repay a loan that the ESOP takes out to buy company shares are also tax-deductible. Employees pay no tax on their ESOP contributions – only on the distribution of their accounts.
However, ESOPs do come with limitations. The law does not allow ESOPS to be used in partnerships and most professional corporations. They can be used in S corporations, but those corporations don’t qualify for the same rollover as other businesses and have lower contribution limits. They are also potentially expensive: The cost of setting up an ESOP is significant, and private companies must repurchase shares of departing employees.
Ultimately, whether or not an ESOP is the right ownership future for your business depends on the specifics of your company. They can be tricky to manage, but for some owners they may be the right business succession plan.