Forms of Employee Ownership

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.

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.

Companies of various sizes and stages seeking a low-cost, gradual, flexible ownership transition.

Typical goals for these plans include employee engagement and the creation or maintenance of a strong ownership culture.

Companies are typically S corporations or C corporations.

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.

• Recruiting, retaining, and incentivizing employees.
• Providing liquidity for owners, either gradually or, in the case of a leveraged transaction, more quickly.
• Providing a tool for a gradual & flexible ownership transition and leadership succession.

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.

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.

None for the sale.

Combined with a stock donation program, capital gains tax on the donated stock is potentially eliminated. Such donations likely qualify for a deduction in the year of the donation.

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.

Stock grants would be a deductible expense if they are included as part of a comprehensive compensation program.

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.

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

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.

Employees use after-tax dollars to buy stock; employees pay ordinary income taxes on stock grants; sellers pay capital gains tax when stock is sold.

S corporations- Company income passes through to employee-owners. The company typically pays distributions that at least cover the employees’ tax obligations.

C corporations - Dividend income, if applicable, is taxed at capital gains rates.

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.

Companies can choose which employees they want to include, but typically all full-time and part-time employees are eligible to purchase stock. All or some employees are typically eligible for stock grants and/or stock bonuses.

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 ($305,000 in 2023, indexed annually) does not count.

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

Companies choose their own formulas for profit 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.

Employees can decide to purchase any amount of stock within minimum and maximum limits.

Stock grants and/or stock bonus can be performance-based and/or used to encourage stock purchases, similar to a 401(k) plan match.

Vesting must be complete after six years 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.

Employee stock purchases vest immediately upon the purchase of stock. Companies determine their own vesting rules for stock grants.

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 profit shares from the company.

Employees normally receive annual patronage dividends.

Companies set their own rules. Employees typically hold most or all of their stock long term. The company typically provides some flexibility to sell stock at any time and for employees to sell stock incrementally as they approach retirement.

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.

• Shares of company stock are typically voting shares. 1 share = 1 vote.
• Owners elect the board of directors.
• Board of directors oversees the company's strategic direction and ensures accountability.
• Executives manage day-to-day operations and implement board-approved strategies.

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.

A valuation is typically performed annually, effective December 31st of each year, which sets the price to buy and sell shares throughout the following year. This is at fair market value, generally as determined by an outside appraiser. Rather than seeking a strategic buyer, founders and major shareholders typically sell shares incrementally over time while continuing to participate in the success of the company.

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.

There are no fiduciary issues.

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.

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.

Initial costs can range from $10,000 to $50,000 and can include the valuation, legal documents, and implementation fees if needed.

Learn more about implementation.

Ongoing costs include the annual valuation and administration of stock purchases and stock sales, which is minimal.

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.

Can be done without financing.

Financing can be used to accelerate liquidity for retiring owners through employees, lenders, and/or seller notes.

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.

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.

Direct employee ownership is not covered by any specific set of rules and is less complicated and more flexible than an ESOP to set up and administer.

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.

Companies looking for tax-favored means of providing liquidity are not good fits for direct employee ownership.

Companies uncomfortable with engaged employees who are thinking and acting like owners are not a good fit for direct employee ownership.