Some 401(k) plan sponsors offer company stock as an investment option in their retirement plans, but a true employee stock ownership plan (ESOP) is one in which all eligible employees—from rank and file to managers and owners—have a piece of ownership of the company through the ESOP, which only has company stock—except for a little cash—as an investment.

However, with frequent company stock lawsuits against 401(k) plan sponsors and Department of Labor (DOL) litigation regarding company stock purchase transactions, one wonders if sponsoring an ESOP is a good idea.

Not only is it a good idea, but when speaking to experts, the idea of succession planning is a common theme.

Mark Kossow, a member at Clark Hill law firm, whose practice is focused on ESOPs, based in Princeton, New Jersey, says retirement plan company stock investment lawsuits are outlier cases. He points out that there is empirical evidence that ESOP-owned companies are more profitable. “The value of the benefit as a retirement plan will be beneficial to employees and employers,” he says.

According to Joanne Swerdlin, executive vice president, Swerdlin & Company, an Ascensus company, who is based in Atlanta, there are more plan assets in ESOP accounts in this country than there have ever been before, and ESOPs are creating more wealth for more people every day. She says the fact that the DOL is litigating certain abuses should give participants comfort that there’s a commitment to effective oversight and getting rid of bad actors in the industry.

Which employers should sponsor an ESOP?

According to Swerdlin, ESOPs operate successfully across a broad range of industries—large and small, public and private. But most ESOPs are established by private companies. She adds that the ideal private company candidate for an ESOP will be one that has strong cash flow and a history of increasing sales and profits, is in a high federal income tax bracket, is not heavily leveraged and has substantial stockholder equity and has capable second-line management in place.

Kossow says business owners with paternalistic feelings for employees are prime candidates for ESOPs. When business owners sell to a third party, that entity may consolidate operations, move the company elsewhere, lay off employees or change the company name. “It could hurt employees. When owners sponsor an ESOP, they have full control of the future of their organization,” he says.

He adds that ESOPs can work well for small, medium or large organizations. “It’s the culture instilled of the pride of ownership that results in the company doing better,” Kossow says.

However, he notes that if the company is too small, it may not be a good candidate for an ESOP. “There are certain rules that if a plan is too small it may be subject to excise taxes, so if a business has fewer than 20 or 15 employees, it should look at whether it is feasible to do an ESOP transaction,” he says.

Lisë Stewart, director of the Center for Family Business Excellence at accounting firm EisnerAmper, as well as founder of Galliard International, a provider of transition services for small businesses, says the presence of loyal, effective managers in the company is an important factor. 

“We have found that employers who don’t believe they have family members who are interested or eligible to take over the business, but have loyal, effective, viable managers in the company who are interested in running and owning the business, but don’t have the financial resources to do so, are more likely to consider an ESOP,” says the Iselin, New Jersey-based Stewart. “In addition, the current owners need to be able to withstand the slower payout period and to be willing to give up the leadership of the company as the stock transfers to the employees. The current owners need to have a high level of trust in the current management team, good communication skills, a willingness to work with a board and a thorough understanding of how ESOPs work.”

She adds that ESOPS can be an effective option for mid-sized companies that can afford the administration fees and are willing to work within the mandated structure. “Over the past 35 years, approximately 40,000 U.S. companies have decided to engage in the ESOP process, often because they are able to create some shareholder liquidity, without selling all of the company (a partial ESOP) and therefore, they get the cash, but don’t have to relinquish full control of the business. This is a very attractive option for many owners,” Stewart says.

Jerry Ripperger, vice president of consulting at Principal in Des Moines, Iowa, says ESOPs offer tax advantages, build retirement savings for employees and allow employers to reward and recognize employees for building the value of the company.

Stewart explains there are multiple tax advantages associated with an ESOP for both the seller and the new “owners”—the owner sells his stock in a tax-free transfer and the employees can save proceeds on a pre-tax basis. It also allows for a gradual transition of control throughout the transfer and may last indefinitely if the owner or owners decide not to transfer all of the stock. It can be an opportunity to train the emerging leaders, enhance the management skills and engage employees across the organization over a reasonable amount of time, leading to more stability.

Swerdlin points out that ESOPs are also sanctioned under IRC Section 4975 with the ability to borrow funds to purchase those securities from a company or a shareholder without incurring a prohibited transaction violation. “These applications under IRC Section 4975 give an ESOP its unique ability to serve as a tax-efficient, ready-made market to buy out shareholders—and not just for one transition,” she says. “A well-designed ESOP with a well-managed ‘repurchase obligation’ strategy is an effective ongoing transition tool that provides retirement benefits for many ‘owners’ over future years, not just the original founders.”

Swerdlin adds that a gradual buyout may give a younger owner the opportunity to diversify some of his investment in the company that he’s worked hard to build, instead of selling completely out and going to work for a new owner (or just moving on). It may give an older owner time to groom trusted managers or recruit new talent to build a stronger management team so that he can truly retire knowing the company he worked so hard to build is in the best hands.

“From an owner’s perspective, a major benefit of selling to an ESOP versus a third-party is the overall transition/sale can occur completely on the shareholder’s timetable,” she says.

Potential issues with sponsoring ESOPs

On the other hand, Swerdlin says, repurchase obligation in an ESOP can be a problem when people don’t understand it or listen to stories from companies that haven’t effectively managed it. “We often hear people say that just the thought of it is the main thing that keeps them from considering an ESOP as a transition strategy. The truth about a repurchase obligation is that it is merely a systematic cash-flow plan for buying individual ‘owners’ out as they retire. The difference is that funding the plan to pay out ESOP accounts as participants retire is actually a gradual buyout of smaller ownership values over time, instead of an immediate large buyout of the whole company at one time,” she explains.

Stewart also says it can be very difficult for owners to relinquish control. “It may sound like the perfect solution, but many owners struggle when they see the new or emerging leaders doing things differently or making what they believe are poor decisions. In addition, there are times with family members who own stock may disagree about the continued stock transfer arrangements, leading to ongoing negotiations and sometimes litigation,” she says.

Stewart adds that not all employees are excited or even comfortable with the concept of an ESOP.  Those who administer ESOPs like to point out that they increase productivity and profitability, but Stewart contends this is not always the case. “Much depends upon the skills of the leadership team and the strategic abilities of the board,” she says. “Education and training is important to make sure that the program can work. Employees won’t realize any benefit to their ownership until they retire or leave—so they may not see any short-term advantage.”

According to Kossow, plan sponsors need to remember that an ESOP has to have a trustee that has control over assets and considers buys and sells. They want an independent trustee in place to decide whether a purchase is feasible from the ESOP perspective, who doesn’t have a conflict of interest that a business owner would in making the decision. “Protecting the transaction itself and therefore protecting participants is the sole mission of an independent trustee,” he says.

“From my perspective, the professionalism of the service providers and the resources available to ESOP participants and sponsor companies have never been greater. There is substantial data to support that ESOP-owned companies outperform their peers, don’t default on their debts, and don’t outsource jobs overseas. In addition, their employees receive about four times the national retirement benefit on average,” Swerdlin says. “Not only does it sound like it’s ‘still a good retirement plan,’ but it also appears that ESOPs are now better than ever.”