How to avoid pitfalls of employee stock option plans while reaping tax, retirement benefits

Thinking about retirement? For those who own a company and are looking to hand control to their employees, an employee stock ownership plan, or ESOP, might be an attractive option, but it doesn't come without risks.

The plans allow a company to set up a trust fund to which employees can contribute cash to purchase company stock, contribute shares directly, or have the plan borrow money in order to purchase shares in the company. If the plan borrows money, the company contributes to it to enable it to repay the loan.

A central benefit of ESOPs are that the contributions are not taxed until employees receive their stock when they leave or retire, and owners can sell out of a business over time.

But the plans do carry risk, particularly for owners who risk losing control of their company as they gradually offload shares to employees. It is also possible a business would not generate enough cash to buy out the owner. Employees also see risk, since if a business goes belly up, their retirement savings potentially do, too, with an ESOP.

We asked North Bay experts to weigh in on the pros and cons of ESOPs from the ownership and the employee perspective. Contributors include Kimberly Hunter, a private wealth financial adviser, managing director for investments at Wells Fargo Advisors; Claudia Stern, a principal in the Forensic and Financial Consulting Services Group at Hemming Morse LLP; Jim Andersen, a CPA and partner at Hemming Morse LLP; and Lillian Meyers of Meyers Financial Services, Inc. Some answers have been edited for clarity.

How can ESOPs be used in business succession planning when an owner is looking to leave a business?

Kimberly Hunter: Employee Stock Ownership Plans can offer a business owner a tax efficient way to exit the business and sell the business to their workers over time.

Lillian Meyers: Employee stock (ownership) plans are a good option if your family is not interested in your business. A plan can be set up to have your employees own the business. ESOP is a qualified retirement plan subject to the regulatory requirements of the Employee Retirement Income Security Act of 1974 (ERISA). One big difference you must note, the retirement plan must have more than half of the investments in your company stock.

As I work with my clients and working a plan, I always let my clients know that there are always pros and cons to any financial decision you are planning - a positive or negative that happens - and it is important to look at the whole picture.

One of the options that is attractive to your employees is control but the disadvantage to you is the loss of control. You do have a maximum up-front liquidity and the control of the premium.

If you want to stay involved with your company you may have options as the seller to continue to be involved.

Claudia Stern and Jim Andersen: If an owner decides that the business should be transferred to the employees, this is a tax-efficient mechanism for getting the business to buy out the owner and for the employees to take control.

Because the business is the one cashing out the owner, it is imperative that the business have adequate cash flows to support the buy-out. One of the downsides of this method is that the owner may get paid less for the business because they are selling at fair market value and losing the opportunity to achieve a synergistic sale which would generate a premium over fair market value.

The other downside is that the owner may not be able to sell their entire stake at once, so there is risk that the business may not generate enough cash in the future to complete the entire buy-out process.

What are the advantages of this approach as opposed to other methods?

Hunter: The owner can get cash out of the business to retire and diversify while the employees can purchase the business using loans with tax benefits. Therefore, it truly can be a win-win for the business owner and the employees.

Meyers: When you take advantage of leveraging assets to purchase shares, the company conducting the ESOP sells 25% to 100% of the company to its employees. The owners are selling the company to itself. You create equity incentive to all participating employees who want to become owners, so the mindset is to ensure the company is successful. This can also work for recruiting and retaining great employees.

One important aspect is to check out the tax deductions when the company contributes to the plan and the deferral of capital gains to the redeeming shareholders, leading to cash flow.

You must be ready to deal with compliance issues and the recording of the shares. Also, it's important to consider the tax laws dealing with ERISA which leads to needing a professional to manage your plan.

However, the increase in liquidity for shareholders is very attractive and allows for other opportunities to monetize their investments as their shares have cash value, this helps with the exit strategy for the owners.

It can also be a great motivator for the employees, as the company will fund a retirement benefit and buy company stock for each employee.... Claudia Stern and Jim Andersen of Hemming Morse

Stern and Andersen: The primary advantage of this method is its tax efficiency, primarily for the owner but also for the employees. It can also be a great motivator for the employees, as the company will fund a retirement benefit and buy company stock for each employee, and it will be good for public relations.

What are the potential risks of using an ESOP and providing employees with ownership interests in a company?

Hunter: There are risks to the employees and risks to the business owner selling to the employees.

The risk to the employees is that they may end up with a significant amount of their retirement in company stock. Because the business takes on debt to fund the buyout of the owner's share of stock; it could impact the ability of the company to get more financing for other projects.

Stern and Andersen: From the owner's point of view, the risk is the business will not generate enough cash to buy-out the owner. If the owner is handing over control or selling more than 50 percent of the ownership, the owner may not be able to prevent management from taking on risks or otherwise running the business in a way the current owner doesn't like.

From the employee's point of view, the company will be putting retirement contributions into company stock which increases an employee's financial risk. If the company fails, not only will the employee lose their job but their retirement savings will be worthless.

Finally, there are a lot of risks with the regulatory responsibilities of the ESOP. The ESOP is a trust, and must be run to benefit the employees. Every employee has the potential to file a lawsuit against the ESOP's trustees and advisers for failing to do their fiduciary duty.

Are companies increasingly considering using ESOPs in the business succession context?

Hunter: Absolutely, as taxes have gone up for individuals in California, business owners want the most tax efficient way to take some or all of their equity out of their company and keep more of their hard earned dollars in their pocket.

Stern and Andersen: ESOPs were very exciting when they first became available and were often used in situations where they were destined to fail. After seeing succession failures, there is more caution about when they are appropriate and when they are not.

What would be some mistakes a business owner could be susceptible to when going this route?

Hunter: The key mistake I have seen is that the business owner put an ESOP in place without having the right management team in place who could continue the business momentum and inspire the staff.

Another mistake I have seen is where the business owner took too much cash out of the business and really strapped the company's operating cash flow with the debt and put the company in a tough position to get more financing when the business needed it.

Stern and Andersen: The biggest mistakes we have seen would involve two issues: First, not enough cash is available from operations to support the buy-back. Second, the current owner remains in control and does not understand the formalities that must be observed when the ESOP is formed, i.e., sloppy accounting and inadequate annual valuations, which led to multiple lawsuits.

The company must be stable, have lots of cash flow and a willingness to give up control. Lillian Meyers of Meyers Financial Services

Meyers: Mistakes a business owner could make: not hiring the best professionals; not wanting to pay for continued management; not being ready to give up control or ready to exit out.

Companies are increasingly looking at the options of using an ESOP in their business succession planning. The company must be stable, have lots of cash flow and a willingness to give up control. In the end it is up to the business owner to see if your business has the unique needs with beneficial results from the business. It has to make the most sense to the owner and the business.


Staff Writer Chase DiFeliciantonio covers technology, banking, law, accounting, and the cannabis industry. Reach him at or 707-521-4257.

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