Is an Employee Ownership Plan Right for You?

As Baby Boomer business owners are now reaching an age where they need to plan for business transition, one option they should be considering is an employee stock ownership plan (ESOP). There are several convenience store chains with these plans, including Sheetz Inc., Stewart?s Shops, PDQ Food Stores Inc., Rocky Top Markets, Pester Marketing Co. and others. The plans range anywhere from 11-percent ownership at Pester to 100 percent at PDQ.

But perhaps the company that has shown the most commitment to the idea is Wawa Inc., the innovative chain with an often fiercely loyal customer base. Howard Stoeckel, Wawa?s vice chairman of the board and author of ?The Wawa Way,? set up an ESOP in 1992 (before that, the company stock had been in a profit sharing plan set up in 1977), which as far as we know was the first ESOP in the industry. The plan covers more than 10,000 employees and owns about 48 percent of the company?s shares.

Stoeckel could have sold the company to another buyer, but speaking at a commencement ceremony at Rider University, he said what has most gratified him at Wawa is ?seeing people grow and achieve their dreams ? people that came to us with a high school degree who have worked their way through the organization. People are judged by the people they leave behind, and I?m proud of the people I left behind.?

An ESOP has allowed that vision to continue. Today, Cathy Pulos, senior vice president, chief people officer and chief financial officer, says that ?Wawa?s culture is based on private ownership, shared ownership and a commitment to living our core values.? She notes that ?associate ownership [employees are called and treated as associates] has a unique place in Wawa?s history, future and culture.?

HOW ESOPS WORK

Many business owners want to leave a legacy they can be proud of. Many also want to continue to play some role in the company, whether in ongoing management, serving on the board or acting as an advisor. ESOPs also have significant tax benefits as a tool for business transition. ESOPs are flexible and make all of this possible.

ESOPs can be set up to own any percentage of the company and can buy shares all at once or in stages. Finally, if companies do what Wawa has done so well ? going beyond simply sharing ownership to also sharing information about company performance and involving employees in day-to-day decisions about how their job is done ? research definitively shows they will typically easily outperform competitors. But ESOPs are not just ?feel good? plans. Congress intentionally set up ESOPs to be the most tax-favored way to do a business transition. For instance:

• For the owner of a C corporation, proceeds on the gain from the sale to the ESOP can be tax-deferred by reinvesting in the securities of other domestic companies. If these securities are not sold prior to the owner?s death, no capital gains tax is ever due. If the company is a S corporation, LLC or partnership, it can convert to a C corporation before the sale to take advantage of this tax deferral.
• ESOPs are funded not by employees, but by tax-deductible contributions from the company to the plan to buy shares. This kind of corporate stock redemption is not normally deductible. So, if an owner sells $5 million in shares through a corporate redemption, the company normally must make about $8 million in pretax money to leave $5 million for the purchase. An ESOP sale only requires $5 million.
• Employees are not taxed on the contributions until they take a distribution after they leave the company, and then are taxed as in any other retirement plan.
• In S corporations, the percentage of profits attributable to the ESOP?s ownership is not taxable. A 30-percent ESOP pays no tax on 30 percent of the profits; a 100-percent ESOP pays no tax.

WHAT IS AN ESOP?

To get these benefits, however, companies must comply with a variety of rules. An ESOP is a kind of employee benefit plan, similar in many ways to qualified retirement plans and governed by the same law (the Employee Retirement Income Security Act).

ESOPs are funded by the employer, not the employees. Stock is held in a trust, at least for all employees working 1,000 hours in a year, and is allocated to employees based on relative pay or a more level formula. The stock is then distributed after the employee terminates, with some flexibility in paying out over time. Employees must vest over not more than six years. ESOPs cannot be used to share ownership just with select employees, nor can allocations be made on a discretionary basis.

The plan is governed by a trustee who votes the shares, but the board appoints the trustee, so changes in corporate control are usually nominal unless the plan is set up by the company to give employees more input at this level. Companies can pass through full voting rights if they want, however.

FINANCING & VALUATION

The simplest way to use an ESOP to transfer ownership is to have the company make tax-deductible cash contributions to the ESOP trust, which the trust then uses to gradually purchase the owner?s shares. Alternatively, the owner can have the ESOP borrow the funds needed to buy the shares. In this way, larger amounts of stock can be purchased all at once, up to 100 percent of the equity. Loans can come from banks or, as is increasingly the case, from sellers taking back a note at a reasonable rate of interest (currently about 5 percent to 9 percent).

The price the ESOP will pay for the shares must be determined at least annually by an outside, independent appraiser. Generally, all full-time employees who have worked for a year or more must be eligible to be in the plan. Allocations in the plan are based on relative pay or a more equal formula. Distributions are made after termination on a flexible basis, with the employees putting the shares back to the company or being bought out before they leave.

ESOPs are not for everyone, however. Companies generally need to have at least 15 to 20 employees to justify the costs of setting up and maintaining the plan. Typically, the costs range from $60,000 to $120,000 ? a lot, but less than what it costs to sell to a third party.

Companies also must have qualified successor management. An ESOP can pay what a financial buyer would pay, but not what a synergistic buyer, such as a competitor, might offer. Companies need to be profitable enough to buy the shares, as well. For companies that do meet the basic criteria, however, an ESOP is well worth considering.