Advantages and Disadvantages of an ESOP

In a previous post, I discussed the structure of an Employee Stock Ownership Plan.

For those considering an ESOP as an exit option, here are a few advantages and disadvantages of this strategy.

Advantages of an ESOP

The tax benefits of an ESOP exit strategy can be significant. These benefits accrue to the selling shareholder(s) (the corporation), and to the employees who participate in the ESOP. The tax benefits to the selling shareholder and corporation vary depending on whether the corporation is taxed as an S-corporation or as a C-corporation.

Non-tax advantages of an ESOP exit strategy are many and also should be considered by the business owner depending on the owner’s goals. Some of these advantages are:

• A ready-made market for the owner’s stock
• A ready-made buyer for the owner’s business
• A lower marketability discount (typically 5 to 10 percent) when valuing shares on a “fair market value basis” vs. a “strategic market value basis”, since the ESOP is the market for those shares
• A business owner who can gradually transition the ownership over a period of time and thus remain actively involved in the business
• A vehicle for the owner to receive the desired liquidity without selling to a competitor or other third parties
• A retirement benefit for employees
• An avoidance of integration plans and their associated costs to restructure operations, reorganize management or reduce staff because management and staff continue in place after the transaction closes
• An avoidance of giving out confidential information to a competitor or other potential buyers
• A long-term financial investor (the ESOP) that will not seek to sell the corporation in a relatively short time period

Disadvantages of an ESOP

There are also several disadvantages of ESOPs to consider. Like most business decisions, there are trade-offs with any exit strategy. An ESOP is no different.

It is important to remember that an ESOP is a qualified retirement plan governed not only by the Internal Revenue Code, but also by the fiduciary and disclosure rules of ERISA. High fiduciary duty standards must be met. This adds additional costs to the corporation including the cost of:

• Retaining an independent trustee, an independent financial advisor and independent legal counsel to advise the ESOP trustee
• Engaging qualified ESOP counsel experienced with ESOP stock purchase transactions in addition to corporate counsel
• Ongoing administrative, fiduciary and legal expenses associated with an ESOP that might not be present in a sale to a third party
• Maintaining the ESOP plan and trust documents, a record-keeper/third-party administrator, a trustee and annual valuations of the share value of the ESOP
• Calculating the amounts of tax-deductible contributions made to the ESOP each year
• Monitoring who can participate in the ESOP depending on the Code section 1042 election, even if they are employees of the corporation
• Implementing the anti-abuse provision, Section 409(p), which restricts any one participant or family from receiving excessive share allocations in the ESOP or other synthetic equity issued by the corporation
• Obligating the corporation to have a stock repurchase plan (this requirement must be monitored and funded on an ongoing basis for participants who are eligible to receive a distribution of their ESOP stock accounts as they retire or terminate employment. The corporation is then required to repurchase the stock at the current fair market value).

As can be seen from the discussion above, ESOPs are highly technical and complex. If a business owner is considering an ESOP as an exit strategy, careful planning and retention of experienced professional advisors, including a wealth management firm, a qualified ESOP tax advisor and a qualified ESOP transaction law firm, are musts.