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shares many rules with 401(k) plans, ESOPs are funded by the
company instead of the employees. Therefore, the company
should be " reasonably consistently profitable, " he advises.
Company size matters, too. In a book published by NCEO,
" An Introduction to ESOPs: How an Employee Stock Ownership
Plan (ESOP) Can Benefit Your Company, Its Owners and
Its Employees, 19th Edition, " author Scott Rodrick recommends
that the company be in the top corporate tax bracket
and have, at minimum, 20 employees and a payroll of at
least $250,000. Companies below those thresholds probably
will find the cost of establishing and maintaining an ESOP
too great relative to the advantages, he says.
Rodrick estimates that setting up an ESOP likely will cost
a company with 20 employees " $75,000 to $150,000 or more
on legal fees, stock valuation-assuming [the stock] is not
publicly traded-administration and other costs. Fees will be
higher for larger companies and if the ESOP is even partially
leveraged. ... Administrative fees might start at $2,500 or
more per year and increase with the number of participants. "
Transferring ownership to an ESOP is not an all-ornothing
decision, says Scalici, though tax considerations
factor into determining the percentage moved. It is beneficial
to sell at least 30% of the company to capitalize on
some tax benefits that are available to ESOPs, but subsequent
transfers are flexible. " A number of ESOPs will start
as a partial sale, and [later the owner] sells the balance of
the stock, " he says. " [In other cases, owners] will sell 49% so
they still maintain equity control of the organization and
then sell the other 51% at some point in the future. "
Setting Up the Plan
The complexity of setting up an ESOP varies with the format.
The first step is establishing an ESOP trust. The next is
deciding how to fund the trust, and at this stage it can get
complicated. In a non-leveraged ESOP, the company contributes
cash, stock or both to the trust. The ESOP subsequently
uses cash contributions to buy company stock from the
business or the shareholders.
Leveraged ESOPs involve a lender, and the cash flows
and loan repayments are more complex than for non-leveraged
plans. Depending on the selected structure, either the
company or the plan can borrow funds. If the company
borrows the money, the ESOP in turn will borrow from the
company and use that money to buy shares from the stockholders.
A different twist on the loan arrangement is for the
ESOP to borrow from the lender with the company providing
a repayment guarantee.
The variety of funding methods provides flexibility in
structuring the ESOP. In Cornerstone Advisors Asset Management's
case, the owners realized the younger employees
could not afford a significant amount of stock on their own,
so the ESOP was funded through multiple strategies. Scalici
and his partner employed a lateral transfer, whereby participants
could use a portion of their 401(k) plan balance to buy
stock, for about 6% of the sales proceeds. The two also took a
bank loan-a fixed-term note that covered about 34% of the
proceeds. The final piece was a seller's note, which was an
IOU from the company to the owners for the remaining 60%.
" The combination of payments was structured this way so as
not to burden existing employees with personally having to
assume these obligations, " Scalici says.
ESOP or KSOP?
Most traditional ESOPs operate as a standalone plan that the
sponsor provides in addition to a 401(k), says Jerry Ripperger,
national vice president, stock plan services consulting at
Principal Financial Group in Des Moines, Iowa. However, the
similarities between ESOPs and 401(k) plans allow sponsors
to combine the two into what is known as a KSOP. In
Ripperger's experience, it is usually public companies that
offer KSOPs while private companies maintain the ESOP and
401(k) separately.
As most ESOPs, the basis for KSOPs, are at private companies,
this may explain why the latter are relatively rare.
" Many companies have both an ESOP and a 401(k) plan, "
says Rosen. " A KSOP simply combines the two plans into a
single plan document and is administered as a single plan
with an ESOP and 401(k) features. Employers may use the ESOP
portion to match employee deferrals and/or allow employees
to buy company stock with their deferrals, " he says. " Because
private companies, unlike public companies, rarely want to
base their contributions to the ESOP on employee deferrals
and almost never allow employees to buy stock in a 401(k)
plan, they have little incentive to combine the plans. Whether
plans are combined or not, the tax treatment is the same. "
Similarly, " companies may count their contributions to the
ESOP toward the 401(k) safe harbor rules whether the plans
are combined or not. "
The Adviser's Role
ESOPs' technical demands such as for the potential use of
leverage, the tax treatment and the company valuations distinguish
these plans from other DCs. Nathan Voris, director,
investments, insights and consultant services with Schwab
Retirement Plan Services Inc. in Richfield, Ohio, says, as a
result of ESOPs' complexity, he encounters few advisers with
the expertise to manage both 401(k)s and equity plans for
clients. Nonetheless, he says having capabilities in both areas
is becoming increasingly important. First, over one-third of
participants in Schwab's 2020 Equity Compensation Participant
Survey said equity compensation was the main reason,
or one of the main reasons, that they took their current job.
Second, ESOP expertise can help advisers " differentiate their
practice and add more value to the sponsor, " he says.
Equity ownership can also boost employees' financial
well-being. In the Schwab survey, equity compensation, of
all types, comprised an average 32% of employees' net worth,
ranging from 21% for Baby Boomers to 43% for Millennials.
Scalici says Cornerstone's ESOP is growing faster than its
401(k) plan, with the company stock's return exceeding the
broader market's results. " If I look at our plan today, I'd say
there's almost a 50-50 split between the value of the ESOP
and that of the 401(k) plan, " he says. " At least in our situation,
that [ESOP]'s been a big, a big plus. " -Ed McCarthy
planadviser.com January-February 2022 | 31
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