Web Article
September 3, 2021

Employee Ownership for Closely Held Companies: ESOPs, Equity Grants, Trusts, and Worker Cooperatives

The table below is a basic outline of four major approaches to employee ownership. To make the table concise, we have left out many nuances and details.

This table excludes direct ownership. It also excludes ERISA-qualified profit-sharing plans and stock-bonus plans (see the separate article How ESOPs, Profit Sharing Plans, and Stock Bonus Plans Differ as Employee Ownership Vehicles). 

Links to more detailed explanations of various issues are provided where appropriate.

 

Form of employee ownership

 

ESOPs

Equity grants

Employee ownership trusts

Worker cooperatives

What kinds of companies typically use these plans?

Established companies with owners looking to do a partial or complete ownership transition. A minority of plans are used by companies simply to share the wealth employees help create.

Companies must be C corporations, S corporations, or LLCs taxed as a C or S corporation.

Often used by newer companies looking to grow or by larger private companies.

Most private companies using these plans intend to be sold in the medium term, but some provide liquidity through company redemptions and stay private.

Companies looking to do a business transition that want to give legal protection for preserving legacy, community benefit, or social and environmental goals, or that do not want to comply with the rules and costs of an ESOP and are willing to trade off the tax benefits of ESOPs to do so.

Trusts can be designed to be permanent in order to prevent a sale to another buyer, something that may not be possible in an ESOP.

Learn more

Typically, smaller companies with a philosophical commitment to democratic corporate governance.

Companies looking for a lower cost way to set up an employee ownership plan and/or get employee investment up front.

 

 

Primary uses

1. To be a new owner of the business, often when the current owner wants to retire.

2. Providing incentives and rewards broadly to the workforce.

1. Providing incentives and rewards to selected workers or, less often, more broadly.

2. Conserving cash in startup companies.

1. Preserving the culture, protecting the work force, or maintaining a values-based decision-making process. 

2. Business transitions in closely held companies.

1. Starting up a new company, often with a social mission.

2. Business transitions in very small closely held companies.

 

Tax benefits to owners of companies

1. Sellers can defer capital gains taxes on a sale an ESOP if the sales meets certain requirements.

2. The purchase of shares by the ESOP can be funded with pretax dollars out of future profits. Stock redemptions outside of ESOPs must be funded with after-tax dollars.

Learn more about using an ESOP for business transition or about the tax treatment of ESOPs.

None

None

Sellers can defer capital gains taxes on a sale to a worker cooperative if the sale meets certain requirements.

See the section “Deferring Taxation Using the Section 1042 Rollover"  in the article on tax treatment of ESOPs. This provision is the same for ESOPs and worker cooperatives.

Tax treatment for companies

1. Contributions to an ESOP are tax-deductible, including both principal and interest when repaying a loan to the ESOP to purchase shares.

2. The profits attributable to the ESOP trust in an S corporation ESOP are not taxable. 100% ESOP-owned S corporations thus pay no income tax.

For all forms of equity compensation other than incentive stock options, the company receives a tax deduction when the employee recognizes income at vesting or exercise of the award.

EOT companies often pay profit sharing to employees, which is a deductible expense.

Contributions to the employee ownership trust may be tax-deductible to the company.

“Patronage dividends” (dividends paid to members of the worker cooperative, usually based on hours worked) are tax-deductible to the company.

Tax treatment for employees

ESOPs are taxed the same way as other tax-qualified retirement plans are. Employees pay no tax on the contributions to the trust until they receive a distribution of their account balances, generally after termination of employment. Taxes can be further deferred on any amount rolled into another retirement account, usually an IRA.

See When Will I Be Paid? The ESOP Participant's Guide to ESOP Distribution Rules.

If the employee exercises an incentive stock option (ISO) and holds the shares at least one year after exercise and two years after grant, the employee pays capital gains taxes on the increase in value from the grant date.

For all other forms of equity awards (non-qualified options, phantom stock, stock appreciation rights, restricted stock, and restricted stock units), employees pay ordinary income taxes. The timing of the taxes may depend on an election the employee can make for certain kinds of awards to be taxed at grant rather than vesting.

Learn more on forms of equity awards

EOTs often pay annual profit sharing, which is taxable to employees the same way a bonus is, i.e., subject to payroll taxes.

EOTs generally pay dividends to trust participants. These are taxable in the same way other corporate dividends are.

Patronage dividends paid to employees are taxed as dividends. The law is unsettled as to whether the employee must pay self-employment taxes on these dividends, although for other tax purposes, the employees are treated as employees of the cooperative.

Who must be included in ownership plan

Generally, at least all employees who work 1,000 or more hours in a plan year, have a year of service, and are age 21. Companies may choose to include employees earlier. Some segments of the work force may be excluded.

Companies can choose which employees they want to include.

Companies can choose which employees they want to include, but most EOTs include most or all employees.

Most worker cooperatives require some kind of membership fee to join. New members are usually voted in by other members. Plans are designed to be broadly inclusive, and a cooperative principle is universal access to membership.

How are allocations of equity determined?

Employees get an allocation of annual company contributions to the plan based on their relative compensation among eligible employees or a more level formula. Pay over a certain amount ($285,000 in 2021, indexed annually) does not count.

Companies can choose how much to award to each eligible employee.

Companies choose their own formulas for profit sharing or allocation of dividends sharing., The EOT, not the individual employees, own the shares.

If the company is sold, any equity value would generally be divided between employees there at the time of the sale based on a formula the company determines.

Most worker cooperatives do not allocate equity, instead holding it collectively and paying dividends based on hours worked.

If the company is sold, any equity value would generally be divided between employees there at the time of the sale based on a formula the company determines, although many cooperatives include a provision that some of the sale price would go to social purpose.

When do equity allocations or awards become non-forfeitable (vest)?

Vesting must start no later than after the second year of service. A year of service is 1,000 hours in a plan year or, if the company chooses, a smaller number.

Companies determine their own vesting rules. Each grant has its own vesting schedule.

Because there are no actual allocations of equity, vesting is not an issue.

Because there are no actual allocations of equity, vesting is not an issue.

When do employees get paid for their ownership share?

Distribution of the account balances for employees generally must start no later than five years after the end of the plan year for terminations other than death, disability, and retirement no later than one year after the end of the plan year for terminations for these reasons.

Companies set their own rules for when the awards become liquid.

Employees normally receive annual dividends from the trust or profit shares from the company.

Employees normally receive annual patronage dividends.

Governance

The ESOP trust is the legal shareholder. The trustee is appointed by the board. The trustee votes the shares. Employees have limited voting rights unless the company chooses to provide greater rights.

Employees generally have no role in governance as a result of the equity shares.

Companies can choose the control rights the trust exercises and whether employees have any say. The seller generally determines the purpose toward which the trust must operate and what role the employees have in governing the trust. Most trusts are designed to be permanent, however, so that the company is not sold.

Each cooperative member has one vote, and coop members elect the board of directors.

Valuation

The ESOP trust cannot pay more than fair market value, defined as what a willing financial buyer would pay for the percentage of the company the ESOP trust is purchasing. The trustee hires the appraisal firm. Appraisals must be done annually.

ESOPs generally can pay what most other financial buyers would pay, but about 10% to 20% of potential sellers to ESOPs could get a substantial premium by selling to a synergistic buyer.

Companies need either to use an outside appraisal firm or use a method that can produce a similar result.

There are no rules for how shares are appraised, although a valuation is advisable.

Because equity is not allocated to employees, and dividends are not based on share value, there is no need for a valuation. The sale price can be negotiated with the seller.

Fiduciary issues

The ESOP trustee is responsible for assuring that the plan is operated in the best interest of plan participants. This includes making sure the appraisal is done properly and that the plan operates within its rules and the requirements of the law.

There are no fiduciary issues.

There are no fiduciary issues.

There are no fiduciary issues.

Costs

ESOPs generally cost between $100,000 and $300,000 to set up, but can cost more in larger and complex deals. Nonleveraged ESOPs have much lower setup costs. Costs are generally less than the costs of selling to a third party.

Ongoing costs are about $20,000 to $30,000 for most ESOPs, with cost going up with size.

Learn more

Plans generally cost between $10,000 and $30,000 to set up.

Initial costs are generally from $20,000 to $50,000; ongoing costs not significant.

Initial costs are generally between $10,000  and $30,000.

Financing

ESOPs are paid for by the company, not the employee. ESOPs can be financed by annual cash contributions to the plan in a gradual sale, or leverage when the ESOP buys more up front. ESOP loans can come from seller notes, banks, and/or mezzanine lenders

Generally, equity awards are contributions from the company. Liquidity of the awards can come from company repurchases, the sale of the company, and external investors.

The trust is funded by the company.

Financing can come from employees, lenders, and/or seller notes.

Complexity

ESOPs are subject to detailed federal rules and require that the company devote internal resources to compliance. Setting up an ESOP is similarly more complicated than other employee ownership plans, but less complicated than a sale to another company.

To compare selling ESOPs to selling to outside buyer, see the detail in the link.

Learn more

These plans generally do not involve substantial legal complexities.

Because EOTs are not covered by any specific set of rules, they are less complicated and more flexible than ESOPs to set up and administer.

Worker cooperatives are generally relatively straightforward.

When these plans do not fit

1. Because of their initial costs, ESOPs generally do not work for companies with fewer than 15-20 employees.

2. Good candidates for ESOPs need to have successor management in place if the seller is a key corporate officer.

3. Companies must have sufficient profitability to pay the added non-productive expense of buying out one or more owners.

4. Companies must be comfortable with the idea of most employees owning shares. While ESOPs can provide additional equity outside the plan to selected individuals, they cannot base awards on discretionary decisions.

1. These plans are not a way for an owner or owners to obtain liquidity.

2. If companies provide equity awards to employees without a realistic way for these awards to become liquid, they will have little, if any, value for employees and could cause adverse tax consequences for employees.

Companies looking for tax-favored means of providing liquidity are not good fits for EOTs.

Companies uncomfortable with democratic employee control are not good fits for worker cooperatives.