This short book explains the rules, uses, benefits, and other aspects of employee stock ownership plans (ESOPs). It is useful as an introduction to the subject, as an accompaniment to a full-length book related to ESOPs, or as a concise reference for laypeople. Thousands are sold every year, making this our best-selling publication. When bought in quantity, they are usually purchased by consultants who give them to clients who are considering an ESOP; by companies who give them to employees; by people who give them out as part of an educational meeting on ESOPs; or by companies or consultants who give them to managers, boards of directors, or other company decisionmakers.
The 19th edition updates the existing material as of early 2020, with particular attention to the chapter on valuation.
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Although we do not distribute a PDF version of this, you can buy this on Amazon as a Kindle ebook (readable on any device, from a computer, to a phone with the Kindle app installed, to a Kindle reader). You also can buy this at a variety of other e-booksellers: Apple Books, Barnes & Noble, Kobo, Smashwords, etc.
Table of Contents
Chapter 1: What Is an ESOP?
Chapter 2: Types of ESOPs and Their Financing
Chapter 3: ESOP Tax Incentives
Chapter 4: Uses of ESOPs
Chapter 5: Valuing the Company Stock
Chapter 6: ESOPs for S Corporations
Chapter 7: Contribution and Allocation Limits
Chapter 8: Employee Coverage and Entitlement to Benefits
Chapter 9: Distributing Proceeds to the Participants
Chapter 10: Fiduciary Matters
Chapter 11: The Rights of ESOP Participants
Chapter 12: Is an ESOP Right for Your Company?
Chapter 13: Implementing and Administering an ESOP
From Chapter 2, "Types of ESOPs and Their Financing"
Seller financing. As an alternative to bank financing, selling shareholders may wish to finance the ESOP transaction themselves. In this case, the seller(s) would receive a note from the company or the ESOP as payment for the shares. Seller financing has become more common in recent years because of the reduced availability of bank credit and because seller notes require less time, processing, and cost than bank loans and provide a reasonable rate of interest to the seller. Seller notes may pay a higher rate of interest than bank loans secured by the seller, reflecting the level of risk involved, and may come with warrants to allow the seller to share in future increases in the stock price. Because banks and other outside lenders often require a seller to guarantee the loan, and often subordinated debt is required, many sellers decide they are entitled to both an interest rate on the loan and a warrant that compensates for the risk and lower amount of cash in the transaction.
It is preferable for the company, not the ESOP, to provide the note; for example, ERISA limits the terms the ESOP may offer when it borrows money to buy stock. Also, if the ESOP issues the note, the company must fund the payments through contributions to the ESOP, or dividends or distributions on ESOP-held stock, which can unnecessarily complicate matters for the company.
Apart from the question of whether the ESOP or the company provides the note, there are several different ways to structure a seller-financed transaction. For example, in a “one-day loan” transaction, the company borrows the purchase price from a bank, whereupon the following steps happen within the span of a day or so: the company loans the money to the ESOP, the deal closes and the ESOP pays cash for the seller’s stock, the seller loans most or all of that money back to the company, the company repays the bank, and the company provides a note to the seller to repay the loan. This allows the company, not the ESOP, to provide the note, as discussed in the preceding paragraph.
From Chapter 4, "Uses of ESOPs"
Aside from their obvious use as a tax-advantaged way of providing an employee benefit, ESOPs have a variety of special applications, such as the following.
For business continuity. The most common use of an ESOP is to sell part or all of an owner's interest in a closely held company. In this situation, an ESOP provides substantial advantages over other alternatives:
- It provides a ready market for the stock.
- The company can fund the transaction with pretax dollars.
- The owner(s) may sell to the ESOP partially, or in stages over a period of years so they can gradually ease out of the company—a particularly important consideration for sellers with management responsibilities.
- In a C corporation, the selling owner(s) may defer taxation on the gains by using the Section 1042 "rollover" explained above.
- In an S corporation, distributions that would otherwise be used for shareholders to pay taxes on S corporation income may be used to fund a portion of the ESOP share purchase.
As a tool of corporate finance. A leveraged ESOP can be used to borrow money that could be used to buy another company or new equipment, or to refinance debt. To accomplish these goals, the company issues new shares and sells them to the ESOP in a leveraged transaction, using the proceeds from the sale of new shares to finance acquisitions or to refinance debt. The company raises new capital by allowing the ESOP to buy new shares; this is funded by corporate contributions to the ESOP that come from pretax company cash flow. While this dilutes the ownership of the non-ESOP shareholders, it allows a much less costly repayment of the loan and simultaneously provides an employee benefit plan. If properly structured, the corporation’s growth due to the additional capital will exceed the dilution caused by issuing new shares. A leveraged ESOP can be used to borrow money that could be used to buy another company or new equipment, or to refinance debt. To accomplish these goals, the company issues new shares and sells them to the ESOP in a leveraged transaction, using the proceeds from the sale of new shares to finance acquisitions or to refinance debt. The company raises new capital by allowing the ESOP to buy new shares; this is funded by corporate contributions to the ESOP that come from pretax company cash flow. While this dilutes the ownership of the non-ESOP shareholders, it allows a much less costly repayment of the loan and simultaneously provides an employee benefit plan. If properly structured, the corporation's growth due to the additional capital will exceed the dilution caused by issuing new shares.
Either the ESOP borrows money or, more commonly, the company borrows money and relends it to the ESOP. The ESOP then buys stock from the company, which repays the loan and deducts both the principal and the interest. Companies have used leveraged ESOPs to refinance debt, buy stock back from a public market, acquire assets or other companies, and buy out owners.
From Chapter 11, "The Rights of ESOP Participants"
Annual benefit statement and summary annual report. At least annually, the plan must give each participant and beneficiary a statement of the person’s account balance and vested benefits. The plan must also give each participant and beneficiary a summary annual report disclosing the plan’s assets and annual income or loss.
Notifications of benefit eligibility. Participants and beneficiaries must be notified when they are eligible to receive benefits (including when they are eligible to roll over distributions into an IRA or other plan) and when they are eligible to diversify under the plan (see chapter 8). If the plan receives a domestic relations order, it must notify the affected person(s) (see chapter 9). At least once annually, the administrator must provide individual benefit statements.
Access to plan-related documents. Within 30 days after a request in writing, participants and beneficiaries must be given access to plan documents and any instruments under which the plan was established or is operated (including the SPD, for example), and the Form 5500 annual report made to the government.
Things that do not have to be disclosed. Private company executives sometimes worry that installing an ESOP means disclosing confidential information to the world, but this is not true. The things that participants do not need to be provided include, for example, employee salaries, company financial information, the valuation report, the names and holdings of shareholders, and minutes of shareholder meetings. In other words, ESOP information rights are limited to information regarding the plan, its assets, and rights under the plan. However, communicating some things can be a good idea, such as discussing critical financial numbers as part of a participative management approach that invites all employees to focus on improving profitability (especially since they are now co-owners through the ESOP).