Although almost 7,000 U.S. companies have an employee stock ownership plan (ESOP), many businesspeople are not well acquainted with them. ESOPs are often confused with stock option plans, which are something else altogether. They are not stock purchase plans; employees almost never buy stock through an ESOP. They do not require that employees run the company or even elect the board, unless companies want to structure themselves that way. Most people, in fact, would be well served by forgetting what they have heard or thought about ESOPs before starting to learn more about them. This book will teach you what ESOPs really are, how they work in both C and S corporations, what their uses are, what the valuation and financing issues are, what the steps to set them up are, and much more.
For this updated 2018 version, the authors updated references throughout the book to the current figures for legal limits that are indexed yearly and also revised and updated chapters 1, 2, 4, 5, and 8.
Table of Contents
An Overview of How ESOPs Work
Selling to an ESOP in a Closely Held Company
ESOPs in S Corporations
Things to Do with an ESOP Besides Buying Out the Owner
ESOP Valuation Issues
Financing an ESOP
ESOP Distribution and Diversification Rules
Choosing Consultants and Trustees
ESOPs, Corporate Performance, and Ownership Culture
From "An Overview of How ESOPs Work"
Plans have one or more "entry dates" for employees once they become participants. An employee who has satisfied the plan's minimum age and service requirements must begin participation in the plan not later than the first of (1) the first day of the plan year beginning after the date on which the requirements were met or (2) the date six months after the date on which the requirements are met. Participation can begin at an earlier date, however. Many plans, for example, have entry dates every six months or every year, and employees become participants at the first entry date after requirements are met.
Shares are allocated to individual employee accounts based on relative eligible compensation. Generally, all W-2 compensation is counted, but there is leeway to define compensation differently, such as by excluding bonuses, provided that it does not favor more highly compensated individuals; on a more level formula, such as per capita, by seniority, or by placing a cap on pay that can be considered; or some combination of the two, such as one point for seniority and one for relative pay. If relative pay is not used, however, plans must be tested annually to determine whether any highly compensated individual, generally defined as someone belonging to either the top 20% by payroll in the company or those making more than $105,000 per year (as of 2008), is receiving more than what the relative pay formula would indicate. In that case, the excess must be returned to the plan and reallocated to other participants. Finally, ESOP allocations can be used as a match to employee deferrals to a 401(k) plan, in which case all or part of the allocation may be determined by how much the employee defers. This approach requires complex anti-discrimination testing for both plans. Relatively few ESOPs use this approach.
From "Selling to an ESOP in a Closely Held Company"
As the chapter on financing in this book notes, seller financing (in which the selling owner receives a note from the ESOP for some or all of the sale price) is becoming increasingly popular. This creates issues when the seller wishes to elect Section 1042, however. Seller financing means that the seller will receive a stream of payments from the ESOP over a period of years, but the Section 1042 tax deferral is available only to the extent that the seller purchases QRP within 12 months after the transaction. If the seller does not have other funds available to invest in QRP within 12 months after the sale (as noted above, QRP need not be bought with the actual proceeds of the sale to the ESOP), then he or she cannot fully take advantage of Section 1042. This potentially means that electing Section 1042 treatment would have no value for an owner involved in a self-financed sale to an ESOP. However, the seller can borrow the money to buy QRP and then use income from the QRP to repay the loan taken out to buy it. This is usually done by buying "ESOP Notes," non-callable bonds qualifying as QRP. Banks will usually loan up to 90% of the face value of such bonds.