How an ESOP works.
An ESOP is a stock trust fund financed and supported by your company that manages employee shares. Shares can be contributed by your business or purchased by the ESOP using company funds.
Shares must be awarded in an equitable manner based on salary, seniority, performance, or some other formula. Plans can’t target benefits to a small group of employees or individuals.
Shares are allocated to individual employees and subject to a vesting schedule. Vesting schedules generally run from three to six years, with specified events that trigger an immediate or “cliff” vest of employee shares. Vested shares can either be redeemed for cash (private companies) or the shares themselves.
ESOP trust funds can borrow money to acquire shares and then use cash supplied by your company to repay loans. This ability to borrow and provide an additional source of owner liquidity is one of the reasons why an ESOP is such a popular option for business transitions. Contributions made by your company to the trust fund are tax deductible.
Should I consider an ESOP?
An ESOP’s complexity makes it useful for meeting a variety of financial goals, including:
Transitioning to a new management team – An ESOP can enable you to buy shares or access debt for a transition package. You can also replace qualified securities with certified replacement assets and defer recognition of gains. These benefits vary depending on your company type (C corporation or S corporation) and must be carefully structured.
Offering employee participation in company ownership – Through an ESOP, your employees can become owners. An ESOP provides methods for allocating, awarding, vesting, and redeeming ownership within a secure structure (trust fund) to plan participants.
Allowing owner liquidity in a privately held company – Need access to some of your company’s built-up equity value? An ESOP gives you a market for your shares and funding to purchase them.
Adding leverage at favorable tax rates – An ESOP can borrow money that’s then repaid using your company’s cash contributions to the plan, which unlocks another financial asset to secure debt with deductible contributions and financing costs.
Understand the fine print.
ESOP rules and regulations for plans and trusts vary by company and plan structure. You’ll need technical knowledge to set up an ESOP and administer it properly. Be sure to include the costs of expert advice in your financial planning and pay close attention to the details.
- Tax treatment – S corporation income and distribution tax treatment allows profits to flow into an ESOP without immediate tax liability. Contributions made to your plan in cash and stock are tax deductible. There are some limitations to using an ESOP with partnerships and professional corporations. Talk to a tax professional to learn how benefits must comply with the law.
- Valuation – Regular valuations are required. You’ll need to pay special attention to fiduciary duties and conflicts of interest when setting up an ESOP and its trustees.
- Stock redemption – In certain cases, ESOP plan participants must be able to redeem their stock for cash. Your plan structure should account for cash redemption demands.
- Tax deferral and voting benefits – Employee participants may experience some tax deferral benefits through the stock they’ve received. They also have protected voting rights that will vary depending on your company type. You’ll need special ESOP expertise to handle the trust and technical aspects of your plan. Financing plays a key role in ESOP set up and ongoing administration. Engage trusted advisors like your CPA, attorneys, financial advisors, and Truist relationship manager who can offer strategic financial advice.
You’ll need special ESOP expertise to handle the trust and technical aspects of your plan. Financing plays a key role in ESOP set up and ongoing administration. Engage trusted advisors like your CPA, attorneys, financial advisors, and Truist relationship manager who can offer strategic financial advice.