For many business owners, the idea of exiting their company is unthinkable, but necessary. Whether you're approaching retirement, seeking liquidity or planning for succession, an Employee Stock Ownership Plan (ESOP) offers a compelling, and often underutilized, exit strategy that benefits both the owner and employees. 

How Does an ESOP Work? 

An ESOP is a unique retirement and ownership benefit that allows employees to gain financial stake in the company. As a business owner, you’re essentially selling the company to your employees over time. The process begins with the creation of an ESOP trust, an independent entity that holds company stock on behalf of employees. Eligible employees earn shares based on factors like salary and years of service, with ownership vesting gradually over three to six years. Each year, an independent appraiser determines the stock’s value. When employees retire or leave, the trust buys back their shares, providing them with a cash payout. Voting rights and dividends are typically managed by the trust or a designated trustee.

ESOPs help employees build long-term wealth and retirement security, while offering business owners a strategic succession plan with significant tax advantages for both the seller and the company.

Why Consider an ESOP for Exit?

ESOPs offer flexibility by allowing partial or incremental sales, rather than requiring a full transfer of ownership at once, enabling the seller to retain management control and easing the transition for employees. Sellers can also choose how the ESOP is financed, either through company borrowing or seller-issued notes, allowing them to align the structure with their financial goals. Additionally, the level of employee involvement in making decisions can be customized, ranging from traditional management structures to more participatory models, depending on the company’s culture and objectives.

ESOP Advantages

Some tax advantages of an ESOP include: 

• In C corporations, owners who sell at least 30% of their shares to an ESOP may defer capital gains taxes under IRC Section 1042.
  • In S corporations, the ESOP-owned portion of the business is tax-exempt, which can significantly boost cash flow.
  • Contributions of stock are tax deductible, which means companies can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP, though this means existing owners will be diluted.
  • Cash contributions are deductible. A company can contribute cash on a year-to-year discretionary basis and take a tax deduction for it, whether the contribution is used to buy shares from current owners or to build up a cash reserve in the ESOP for future use.

ESOPs can also help preserve a company’s legacy and culture because:

• Unlike third-party sales or private equity buyouts, ESOPs keep the business in the hands of those who helped build it. This can be especially meaningful for owners who value their company’s culture and want to reward loyal employees.
  • Employees that become owners can share the benefit of stock price increases. As a result, employee owners typically demonstrate a stronger commitment to the success of the business and are more vigilant in identifying risks or potential challenges that could affect organizational outcomes.

Is an ESOP Right for Your Business?

Determining if an ESOP is right for your business starts with your long-term goals. An ESOP is ideal for owners who want to preserve company culture and provide employee security. They work best for profitable, financially stable companies with a strong leadership team, at least 25 employees and Earnings Before Interest, Taxes, Depreciation and Amortization (EBITDA) of $2 million. Their tax-advantaged structure also helps ensure ESOPs remain resilient during economic downturns.

With an ESOP, valuation, compliance and fiduciary responsibilities must be carefully managed, often with the help of experienced advisors.

Final Thoughts

ESOPs are worth serious consideration for owners who are seeking an exit strategy that preserves their company’s culture, is tax efficient and has an employee-centric approach. Whether your company is considering creating an ESOP as a way to engage key employees, create cash-flow opportunities or facilitate a thoughtful exit strategy, Doeren Mayhew provides the specialized support you need through all its stages, from planning to maturity. We understand the dynamic plan workings, how to protect plan assets and traverse the complex plan structure and compliance issues. Rely on us to support you with assurance, tax advisory and business valuations throughout the process. We know ESOPs.