ESOPs have many advantages, but they don’t work for every business. For starters, rules and regulations governing this plan are not simple.
- A vast majority of so-called non-highly compensated employees must participate in the plan to qualify for its tax advantages.
- IRS rules governing maximum plan contributions allowed per employee are strict. The maximum is typically 25% of pay, up to certain limits.
- Companies need sufficient cash flow to pay their ESOP loan debt. They also need enough cash to buy back stock from employees who depart the company.
- Communicate distribution rules to employees is important. These rules are the same or similar to those of a 401(k) plan. For example, most distributions taken before age 59½ are subject to a 10% IRS penalty, plus regular income tax.
- Costs to start up an ESOP are substantial, ranging from $15,000 to $100,000 and more. These costs include setting up a trust, which buys and holds ESOP stock.
- Valuations must remain current. An ESOP can buy only fairly valued stock, best appraised by a qualified appraiser.
Plan for the Future
Even the most difficult of these requirements is manageable. You can give employees a financial stake in the company and still maintain control Or, you can cede majority control to employees by selling more stock to your company ESOP.
For those companies choosing to start and maintain an ESOP, the benefits are tangible. As you gradually (or all at once) sell your company to this plan, a workforce motivated by company ownership can increase the value of your enterprise through higher productivity. This can result in a higher valuation and selling price when you exit the business.