Web Article
September 25, 2020

How to Choose an Employee Stock Plan for a Closely Held Company

Many companies we encounter have a pretty good idea of what kind of employee ownership plan they want to use, usually based on specific needs and goals. However, sometimes they might be better served by another kind of stock plan. Others say they'd like to have an employee ownership plan, but they're not sure what it might be. This article will start you down the path to choosing the plan or plans best suited to your company.

If you are choosing a stock plan for a closely held company, the first question to ask is, what are your goals for employee ownership? We see a few common answers:

  • We are a closely held company and would like to use employee ownership to purchase shares from one or more owners.
  • We are not looking to sell shares right now, but we would like to provide employee ownership as a reward for most or all of our employees.
  • We are a relatively new company and want to provide an equity stake in the company for key employees.

If business transition is the goal, then an employee stock ownership plan (ESOP) is usually the best choice because it has such favorable tax treatment. An ESOP is not to be confused with stock options or a generic way to share ownership. It is a specific plan set up by federal law that provides substantial tax benefits to owners, companies, and employees. ESOPs are almost always funded by the company, not the employees.

For some very small businesses, an ESOP is too costly to set up, while for others its rules may not be acceptable. In that case, employees can buy the shares directly. This can be very difficult to do and has unfavorable tax consequences, but it can work in some cases.

If you want to provide ownership broadly but are not looking to sell, an ESOP may still be the best choice. You can fund the plan by making tax-deductible contributions of new or unissued stock to the ESOP trust. The tax advantages of ESOPs come with rules about who gets shares and in what way, and if these do not work for you, or the costs of setting up the plan are too high, then another choice is to provide individual equity awards to employees through stock options, restricted stock, stock appreciation rights, or “phantom” stock. These generally have no special tax benefits, but they are very flexible in terms of who gets how much with what rules.

This article briefly explains what each of these approaches is with links to longer articles on our site and to the NCEO publications that can take you step-by-step through the various approaches.

Using an ESOP for Business Transition

This is the most common use of employee ownership in the U.S. When owners want to sell, in many cases they could sell to another company or a private equity firm. But that often means the legacy they built gets absorbed into some other company. Jobs may be cut, the company may be relocated, and the owners usually have few options about what their continuing role in the company will be.

An ESOP provides a great option for many companies. In an ESOP, the company sets up an employee stock ownership trust. It is the same kind of trust that is used for 401(k) plans and other retirement plans, and many of the rules are the same.

The company funds the ESOP trust in one of two ways. It can make annual discretionary cash contributions to the trust, which the trust then uses to buy shares from owners wanting to sell. Or (and this is more common), the company can borrow money to loan to the trust, which the trust uses to buy a block of shares, even up to 100%. Loans can come from banks and/or seller notes. Essentially, the company is redeeming its stock. But in a normal stock redemption, the money used to fund it is not tax-deductible. In an ESOP, it is. Say you are in Minnesota, for instance, and want to redeem $4 million in stock. Federal and state income tax comes to 31% for your company. To end up with $4 million, you need $5.8 million in profits. With an ESOP, you just need $4 million.

When the shares go into the ESOP trust, they are allocated to at least all full-time employees who work 1,000 hours in a plan year. Allocations are based on relative compensation, are subject to vesting over up to six years, and get distributed after an employee leaves the company. If employees have received shares instead of cash, they can then sell the shares back to the company.

Sellers to an ESOP in a C corporation can defer taxation on the gain from the sale if they meet certain requirements by reinvesting in stock and bonds of U.S. companies. There is no other way to get the tax benefits an ESOP provides in an ownership sale.

In an S corporation ESOP, profits attributable to the trust are not taxable. S corporations that are 100% ESOP-owned, who if not ESOP-owned would generally pay distributions to their shareholders to fund their tax bills, have no income tax payments to fund at all.

Shares are valued based on an outside independent appraisal. ESOP rules do not require employees to be able to vote for the board or otherwise get involved in management decisions. The legal shareholder is the ESOP trust, governed by a trustee, usually an outside firm for at least the sale of the stock to the plan. Trustees can be insiders on an ongoing basis, or the company may stick with an outside firm.

ESOPs are costly to set up ($80,000 to a few hundred thousand dollars), but less costly than the sale of the company to another buyer. Their ongoing costs are not a significant factor for the large majority of companies.

To be a good ESOP candidate, a company needs to have successor management, enough profits to pay for redeeming the shares, and, generally, at least 15 to 20 employees, both to absorb the costs and because some of the rules for ESOPs can make it tricky for very small companies.

To learn more about using an ESOP for business transition, read our article Using an Employee Stock Ownership Plan (ESOP) for Business Continuity in a Closely Held Company. To compare an ESOP to other ways of selling a company, read our article Are ESOPs Really More Complex Than Other Ways to Sell a Business? For a detailed look at how this works, see our book Selling to an ESOP.

Sharing Ownership Broadly with Employees

If your goal is not to sell but to share ownership widely with employees, an ESOP may still be a good choice. The rules are the same, but the plan would be financed by tax-deductible contributions of shares to the trust. Unlike many other forms of equity plans, the shares would not be taxable to employees on vesting but rather when they are distributed to them and can be sold.

But some other companies are not comfortable with the rules for ESOPs. For these companies, individual equity grants are a better choice. These grants, which are described below, are most commonly given to a select group of people, but they can be given broadly and often are in entrepreneurial companies as well as most publicly traded technology companies and some other companies, such as Starbucks and Southwest Airlines.

For more information on choosing an equity plan, see our book The Decision-Maker’s Guide to Equity Compensation.

Sharing Equity with Select Employees

Many companies, especially relatively new companies, want to share equity with select employees as a way to attract, retain, and/or motivate them. In some cases, they want them to buy shares, but this is not usually a practical option because employees generally do not have either the disposable income, the risk tolerance, or both.

There are a number of ways to provide these grants:

  • Stock options: Stock options provide an employee with the right to purchase a certain number shares at a set price (usually the current value of the shares) for some number of years into the future, usually five to ten. The award is subject to vesting rules, either based on service, performance, or both. With a nonqualified stock option, when the employee exercises the right to buy the shares, the spread between the price at which they were granted and the exercise price is taxed as ordinary income to the employee and is deductible to the company. In an incentive stock option plan, if the employee holds on to the shares for at least one year after exercise and two years after grant, then the employee does not have to pay any tax until the shares are sold, and then they are taxed as a capital gain.
  • Restricted stock is a grant of shares to an employee with the requirement that the employee can get them only if a vesting requirement is met (again, it can be service-based or performance-based or both). The employees can choose whether to pay ordinary income tax when their award is first granted and then pay capital gains tax on the gain only when they are sold or can choose not to pay tax until the award vests (not when the shares are sold) and then pay ordinary income tax on the value at vesting.
  • Restricted stock units delay giving the employee the right to the shares until they fully vest, when they are taxed as ordinary income.

In closely held companies, a major issue is that all of these awards can be taxed before the shares are liquid, such as when the company is sold or the company agrees to buy them back. So companies must have some kind of realistic liquidity plan or these awards can end up being seen as more a punishment than a benefit.

If a company is just going to buy back the shares when they become taxable to employees or some other point, then the shares themselves have no significance. Largely because of this, many companies choose to provide not actual shares but the right to the value these shares would have. Called “synthetic equity,” these grants are essentially bonuses paid out based on share value or the increase in share value, usually once an award vests.

These plans include phantom stock (an award based on the full value of a number of shares) or stock appreciation rights (SARs) (an award based on the increase in the company's stock value). Employees may receive stock instead of cash, often with the company paying the tax for the employee, and the employee getting the remaining value in shares.

Synthetic equity plans are relatively easy to create and maintain, and they are generally not subject to securities laws.

For more details on choosing an equity plan, see our articles Stock Options, Restricted Stock, Phantom Stock, Stock Appreciation Rights (SARs), and Employee Stock Purchase Plans (ESPPs) and Five Common Myths About Broad-Based Equity Plans, and our book The Decision-Makers Guide to Equity Compensation.

A Note on LLCs

Limited liability companies can also provide equity grants, but in an LLC, employees do not have actual shares but rather membership interests. There are parallel awards in LLCs to the equity grants described above. A major wrinkle is that if an employee gets the equivalent of a stock option (called a profits interest in an LLC) or restricted stock award (called a capital interest), they may be treated as partners, not employees, for tax purposes.

For details on equity awards in LLCs, see our book Equity Compensation for Limited Liability Companies.

Personalized Advice and Suggestions

If you are an NCEO member or if you join us, you can call or email with questions or just to have a general discussion. We always suggest that members who are deciding which plan(s) to use consult with us. Also, you can hire us to speak to your company or provide introductory consulting.

It is crucial not only that you be well informed but also that you hire experienced, qualified, and ethical professionals. Read our article on choosing service providers and then consult our Service Provider Directory.