An employee stock ownership plan (ESOP) is both a retirement benefit plan for employees and a tax-advantaged way for business owners to sell all or part of a business. More specifically, for the employee, an ESOP is much like a 401(k) plan because it is a defined contribution plan sanctioned under ERISA.
Although both an ESOP and a 401(k) are tax-qualified retirement plans, an ESOP is designed to invest primarily in the stock of the sponsoring company. For the business owner, an ESOP is a powerful corporate finance tool, providing liquidity, personal wealth diversification, and tremendous tax savings for owners and their companies. ESOPs are the only succession strategy that allows the owner to pay no capital gains taxes on the sale while creating a tax-exempt company going forward.
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According to the National Center for Employee Ownership (NCEO), there are currently approximately 6,600 ESOPs that cover more than 14 million employees across the United States. Total assets owned by these ESOPs are nearly $1.4 trillion. The ESOP structure is favored by industries that rely heavily on their employees for the company’s success.
The same study reported the level of national ESOP ownership by industry—22% are manufacturing, 19% are professional/science/technical services, and 16% are finance/insurance/real estate companies.
The Midwest and South have historically seen the greatest interest in ESOP ownership. Those areas currently have the highest concentration of ESOP-owned companies with 32% and 30% of total ESOP companies, respectively. In addition, as taxes in the Northeast and on the West Coast have been on the rise, so has the interest in ESOPs. Those areas now have, respectively, 16% and 23% of all ESOP-owned companies.
The History of ESOPs
As individuals learn more about the benefits of ESOPs, they may think ESOPs are “too good to be true” and won’t last. On the contrary, ESOPs have long been embedded in the U.S. financial structure. The idea for ESOPs first surfaced back in 1950, and in 1974 Congress passed the omnibus ERISA law that included the initial framework for ESOPs. Even more important—and a testament to the viability of this succession option—is that the only significant changes to the ESOP section of the law came in a late-1990s expansion to allow ESOPs to own stock in S corporations, opening the door for more ESOPs and greater tax benefits. Once ESOPs were permitted shareholders of S corps, this opened the door for ESOP companies to be fully exempt from income taxes.
There are many business ownership succession options, but none so flexible as an ESOP. In one of our ESOP University sessions titled “Is an ESOP Right for You?” we explore the nonmonetary issues every business owner should consider when looking at ownership succession. While not right for every company, ESOP transactions offer significant tax benefits coupled with unique gifting and estate planning opportunities. And unlike other M&A transactions, a sale to an ESOP keeps information about your business confidential, allows operations to continue in the same fashion and legacy established by you as owner, and is flexible enough to permit a partial or full sale of the company. Plus, you continue to work in the business in your current management capacity.