Considering the ESOP Route for Your Succession Plan? Here’s What You Need to Know

Succession planning - an ESOP allows a business owner to transfer ownership to employees.

Considering the ESOP Route for Your Succession Plan? Here’s What You Need to Know

Succession planning - an ESOP allows a business owner to transfer ownership to employees.

After you’ve worked hard to build a successful business, planning initiatives that look beyond what happens to your business under your watch should become part of your routine to ensure your business’s success. As you look to create a succession plan for you and your company, an option you may consider is an Employee Stock Ownership Plan (ESOP).

What is an Employee Stock Ownership Plan?

An ESOP is a qualified defined contribution retirement plan, providing a benefit to employees that is tax-deferred, similar to 401(k) employer contributions. From an exit planning perspective, an ESOP allows a business owner to transfer ownership to the company’s employees. ESOPs are typically leveraged – the company takes out a loan, either from the selling owner or from a third-party lender, on behalf of the ESOP, and the ESOP trust acquires company stock in exchange for a note payable to the company.

While third-party sales and family transfers still top the charts for popular exit methods, interest in the ESOP route has increased over the last several years. According to the National Center for Employee Ownership (NCEO), in 2018, 252 new ESOPs were created with more than 31,000 new participants. The total assets held by the 6,501 ESOPs in the US in 2018 reached over $1.4 trillion. 

What are some potential tax advantages?

The type and level of tax benefits a business and its owners receive will depend on their particular circumstances and ability to meet specific requirements. However, a company can generally deduct its contributions to the ESOP, including those made to repay the loan principal. For income earned by assets owned by the trust, there is typically no income tax assessed until the distribution is made to plan participants.

If, as the owner of a C corporation, you sell your shares directly to the ESOP, you may be able to defer taxes on the gain that otherwise must be recognized. For an S corporation, profits are passed through to the ESOP trust, which is not subject to federal tax. Often, that tax savings is eventually enough to fund the ESOP transaction, and frees up available capital which can potentially increase cash flow and may one day allow the ESOP-owned company to invest or acquire other companies. The selling shareholder and key employees typically participate in stock appreciation rights and other synthetic equity arrangements to provide upside rewards, which can be an effective alternative to ownership incentives available in other exit routes.

When is an ESOP the right choice?

ESOPs can provide business owners with certain flexibilities that other succession plans may not provide. For example, you can remain in effective control until and after you are paid in full, and you have more control over the timing of the sale. Within limits, terms and conditions for selling shareholders can also be tailored to fit the circumstances. 

An ESOP isn’t going to be everyone’s solution. It is best suited for companies with a consistent track record of profitability, a healthy financial position, a strong management team, and generally at least 15 employees. As with other exit strategies, the road to get there involves a lot of careful planning, and hopefully learning, that continues after the sale. Some purchase and sale provisions are in essence dictated by ERISA requirements. But if your goals for your business are employee-focused, an ESOP may be the optimal solution. It can be a great way to ensure the continuation of your company’s culture and legacy.

Both the IRS and DOL oversee ESOP compliance, so set-up and required maintenance can be complex. That’s why having the right professional guidance on your side is essential. ARB’s Employee Benefit Plan Services Team has been working with ESOP-owned companies for over 30 years. We specialize in helping companies, owners, and plan trustees facilitate planning and compliance matters. To learn more or to discuss your employee benefit plan and succession planning needs, contact me today.

by Benjamin Lord, CPA, CCIFP


Ben Lord is a Tax Director and has been with ARB since 2013. He specializes in audit and consulting services for employee benefit plans. Ben manages employee benefit plan audits in an efficient, cost-effective way by customizing services to meet a plan’s specific needs. He also specializes in consulting and financial accounting services for construction, real estate development, manufacturing, and professional services firms.

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