ESOP Pros and Cons, Advantages and Disadvantages (2024)

ESOP Advantages

• Selling C corporation owners can defer taxation: C corporation owners who meet specific requirements in selling to an ESOP and reinvesting the proceeds in stocks and bonds of U.S. companies can indefinitely defer capital gains taxes on the sale under Internal Revenue Code Section 1042, avoiding taxes completely if they hold those reinvested assets until death, when there is a step-up in basis.
• Selling owners can sell any amount, and more later if desired: If you want to sell only a partial stake in your company, most private investors will turn you down, but an ESOP can buy any percentage of the company's stock, optionally adding to it over time.
• If there are multiple owners, the ESOP can buy only from those who want to sell: In contrast, an outside buyer usually wants everyone to sell because they don't want partners in the company.
• Owners can sell to the ESOP at their own pace: Sellers can still work, withdraw into a more limited role, or just leave. Such flexible timing and arrangements are difficult to achieve with non-ESOP sales.
• Selling owners can retain a role in the company: Many owners who sell to an ESOP stay on as board members or are otherwise involved to help guide the company.
• Only an ESOP can use pretax dollars to buy out owners: ESOPs are the only way the company can use pretax dollars to buy out current owners. Other buyers (the company buying outside of an ESOP, or a third-party purchaser) would use after-tax dollars.
• An S corporation ESOP shields the company from taxes: S corporation taxes are passed through to the owner(s), but the company usually pays them distributions to fund their tax bills, meaning it still foots the tax bill. An ESOP is a tax-exempt entity that owes no federal and usually no state tax, so, for example, a 100% ESOP-owned S corporation has no income tax.
• The company retains its identity after the sale: A non-ESOP sale may mean the company is moved out of the community, split up, sold off in pieces, etc., destroying the selling owner's legacy.
• The employees who helped build the company now own it: Many owners are loyal to their employees and would like to see them rewarded, whereas a non-ESOP sale can mean that the employees get nothing and jobs are at stake.
• ESOPs can improve corporate performance: Multiple research studies over the past several decades have shown that ESOP companies with high-involvement work cultures perform substantially better than non-ESOP companies.
• ESOPs add to employee retirement security: The business continuity provided by a sale to an ESOP often means the difference between keeping jobs and losing them due to a new owner selling off, downsizing, or moving operations. Apart from that, however, research shows that when compared to their non-ESOP counterparts, ESOP participants have significantly more retirement assets and employment stability and also perform better on other metrics.

Potential ESOP Disadvantages and Their Counterarguments

See "Actual Reasons Not to Do an ESOP" below for disadvantages that can be absolute hurdles to an ESOP, like not being a profitable company.

• ESOPs can be expensive… The company must pay legal costs to set up the plan and to keep it current and compliant. An ESOP will probably cost a minimum of $125,000 and often a lot more to set up. For most companies with under a few hundred people, annual costs for administration and valuation are about $20,000 to $35,000, plus another $15,000 to $30,000 for an outside trustee if you choose to have one.
• …But they are less expensive than the alternatives: ESOPs are most commonly used for business transition in private companies, and they are not necessarily expensive when compared to the alternatives. If business transition is not your goal, a simple ESOP that receives shares, or money to buy shares, each year can be relatively inexpensive. On an ongoing basis, the ESOP's tax benefits far outweigh its maintenance costs.
• ESOPs are often complex… This is true as far as it goes, but again, the question is, compared to what? Selling to a non-ESOP buyer is very complex and brings various contingencies, as discussed in our article comparing the complexity and costs referenced above.
• …But so are the alternatives in a typical scenario: Again, ESOPs are typically used for business transitions, and the alternatives bring their own host of headaches. And an ESOP not used for a business transition can be much simpler.
• An ESOP can't pay above fair market value and can't match the higher price a synergistic buyer can offer… Sometimes a motivated buyer like a competitor may offer a price the ESOP (limited to paying fair market value) cannot match.
• …But that higher price isn't as good as it looks, and it doesn't include the ESOP advantages: Such a high-priced offer may be only partly in cash and may have various contingencies attached. And no non-ESOP buyer can offer the indefinite tax deferral on the sale proceeds that a sale to a C corporation ESOP does. See Ownership Transitions: ESOPs Compared to Other Strategies for more detail.
• ESOPs are inflexible in some respects… While ESOPs are flexible in many ways, they are subject to legal constraints. ESOP rules require that contributions be allocated based on relative compensation (ignoring compensation above a certain level) or some more level formula. Moreover, everyone who has worked for 1,000 hours in a 12-month period must be in the plan (with certain exceptions, such as employees covered by a collective bargaining agreement). The ESOP rules do not allow companies to direct allocations within the plan to reward specific employees.
• …But plan types that offer flexibility don't offer the ESOP's advantages: Some companies who want an ESOP-like plan use a qualified stock bonus or profit sharing plan, or an employee ownership trust (EOT), but they gain flexibility in return for losing the ESOP's tax and other advantages, such as the Section 1042 tax deferral, the S corporation ESOP tax shield, deductible dividends, and the plan's ability to borrow money from the company or on its credit.
• Closely held ESOP companies must keep repurchasing their own shares… In such companies, the company has an obligation to offer to repurchase (or enable the ESOP to repurchase) shares from departing participants.
• …But any closely held company actually has a repurchase obligation: If you sell shares outside of an ESOP (e.g., to managers), they too will want the company to repurchase them at some point. And if the owner wants to sell, the company must find a buyer or liquidate. It's just that with an ESOP, the repurchase obligation is a regular event.
• ESOPs have ongoing cash demands… If your ESOP is to acquire a meaningful amount of stock, your company will probably need to contribute more to it than you would have to retirement plans otherwise. If there is an ESOP loan, your company will have little flexibility in reducing this demand on cash or managing the timing of payments. Finally, as noted above, if your company is private, it will be responsible for repurchasing shares from former participants, which often amounts to buying back 2% to 5% of shares yearly once the ESOP has been around long enough for people to vest and leave the company.
• …But these cash demands can easily be outweighed by the ESOP's advantages: Even ignoring everything else, on a purely monetary basis the S corporation tax shield can be set against the ESOP's costs.
• ESOPs bring regulatory scrutiny… Both the IRS and the U.S. Department of Labor (DOL) may investigate ESOPs, causing a burden in the demands they make and the risk of penalties or costly measures to cure any defects they may find.
• …But that seldom happens: The number of companies affected is extremely small relative to all ESOPs, although the potential remains.
• Trustees face fiduciary risk… The trustee of the ESOP is held to strict standards of fiduciary responsibility, which may impose costs on the company in the form of insurance for fiduciaries or even litigation by unhappy plan participants. The risk may be borne by an inside trustee (often a company officer) or an outside fee-based trustee. While successful litigation by plan participants is rare, companies need to understand their exposure and take steps to minimize risk.
• …But the actual risk is very low for those who don't behave badly: Our analysis of trustee litigation suggests that the risks of being a trustee in an ESOP with a high-quality team of advisors and a good third-party administrator are extremely low.

"Disadvantages" That Are Actually Myths

• "The employees don't have the money to buy the company anyway": The company, not the employees, funds the ESOP.
• "Management must share financials and governance with employees": This is untrue; the required disclosures revolve around the plan (as with a 401(k), for example), like yearly personal account statements. The most effective ESOP companies are "open book," but it is their choice to do that.
• "ESOPs are too risky for employees": Since the company funds the ESOP, employees are not risking their own money, and having an ESOP does not preclude the company from having a 401(k) plan or any other kind of retirement plan.
• "ESOPs work only in certain industries": On the contrary, ESOPs are found across all industries.
• "We can't do an ESOP buyout because bank loans for it are unavailable": First, you're probably talking to the wrong bank: ESOP loans have a very low default rate, so banks that know ESOPs view them favorably (and we have an ESOP lender directory for NCEO members). Second, if bank credit is unavailable or will not cover the entire amount, sellers can finance the sale directly by taking a note and receiving an equivalent interest rate. Finally, there are other financing options, such as mezzanine debt.
• "ESOPs are difficult for employees to understand and appreciate": That can be true if your company doesn't try, but if you do make the effort, employees can and will realize what the ESOP does for them.
• "ESOP companies do not perform well": Actually, the opposite is true. See Key Studies on Employee Ownership and Corporate Performance for details. The real secret is combining employee ownership with an ownership culture in which rank-and-file employees share in company financial information and become involved in work-level decisions.

Actual Reasons Not to Do an ESOP

• The company is too small: ESOPs typically cost $100,000 or more even for very small companies, so for very small companies (e.g., 20 employees or less), the costs may outweigh the tax and other benefits. Also, if the company is an S corporation, the anti-abuse ESOP rules for S corporations may make an ESOP in a tiny company impossible unless it converts to C status.
• ESOPs only work for profitable companies: Even if the company is not too small, ESOPs work only for companies with enough profits to keep operating successfully while paying the setup and maintenance costs, making ESOP contributions, and (assuming the company is private) buying back the shares as vested participants leave. Companies need to assess whether they have the available earnings for this. ESOPs are not usually good choices for struggling companies or startups that are not yet profitable.
• A synergistic buyer offers a very substantial premium: If price is your primary concern, a synergistic buyer's offer may be the right choice. However, such buyers typically want 100% of the ownership, so a partial sale would be impossible. If the owner does want to sell 100%, the synergistic buyer's premium must outweigh the ESOP's tax advantages (like indefinitely deferring taxation from the sale if certain conditions are met), and the buyer's offer must not contain unacceptable contingencies or uncertain financing.
• There is no successor management: If the seller is the key manager, capable successor management must be in place to obtain an outside loan as well as to help assure that the company will be able to pay for the plan over time.
• The payroll is not large enough: How much can be contributed to the ESOP is a percentage of payroll, so if your payroll is tiny in relation to the company's value, it may be impractical for an ESOP to buy a substantial percentage of the company over a reasonable time span.
• Management is uncomfortable with the idea of employees as owners: While employees do not have to run the company, they will want more information and more say. Unless they are treated this way, research shows, they may be demotivated by ownership.
• Family members or specific executives want a major share of the company: ESOPs can't be used to transfer ownership to specific people; they are inherently broad-based. Furthermore, if the selling owner elects the Section 1042 tax deferral of gains on the sale, their family members (save for a narrow exception for lineal descendants) and any more-than-25% owners cannot receive ESOP allocations of shares from the 1042 sale. However, it is common to have an ESOP and also have other equity-related incentives, such as stock appreciation rights.