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ESOP Pros and Cons in 2022

ESOP pros and cons

Employee Stock Ownership Plans, better known as ESOPs, allow employers to give employees ownership interest in a company in the form of stock. This helpful tax strategy can align the interests of employees with existing shareholders. However, there are both pros and cons to an ESOP.

Cons of an ESOP

To start our discussion of Employee Stock Ownership Plan pros and cons, let’s begin with the potential negatives. 

Administration requirements. Perhaps the biggest con of an ESOP is that it requires continual administration. It’s not something a company can set up and just forget about — it won’t run by itself. Ongoing administration duties include annual valuations, plan maintenance and legal fees. All of this upkeep can get expensive over time. 

Only pays fair market value for sales. Another ESOP con is the potential that shareholders won’t maximize the proceeds from a sale. This could happen because an ESOP is not a strategic buyer, it only pays fair market value to the current owner. The con here, at least for the ownership, is that the ESOP will likely never demand a premium. In other words, ownership will not receive top dollar, only fair market value. 

Not a good fit for small businesses. Yet another ESOP con is that it may not be ideal for smaller businesses or recent startups. This is because many small businesses are LLCs, partnerships and sole proprietors, which are entities that are unable to create an ESOP. Only businesses that are corporations may participate. In addition, for smaller corporations, it could be financially difficult if multiple team members leave around the same time. 

Having several employees leave within a few short months could translate into a steep expense because their shares must be repurchased. In short, an ESOP for a small business could be more expensive than expected early on, especially when cash flow is extra tight. That’s why some would prefer that cash be reinvested into the business operations rather than into starting and maintaining an ESOP.

Pros of an ESOP

Despite the cons listed above, there are many ESOP pros.

Employee motivation. For starters, ESOP shares can make employees feel more invested in their company’s success. This can lead to greater motivation to stay with the business and, therefore, better employee retention rates.

Tax benefits. There are also tax benefits to consider, since ESOPs are tax-exempt trusts. Employees don’t have to pay tax on the contributions to an ESOP. They only pay upon distributions from their accounts, but at potentially favorable rates.

Profits can stay with employees. Another ESOP pro is that profits earned by the company can stay with the employees. An ESOP also allows for gradual ownership transition. This can be helpful if the company wants to gradually shift ownership between partners over time rather than all at one time.

Is an ESOP Right for Your Business?

All in all, there are plenty of pros to ESOPs on both the employee and employer side. Each business must balance out the potential cons and figure out if an ESOP is right in their particular situation.

For more on ESOPs and other potential tax strategies, use a good tax planning software that can show you different scenarios and tax consequences of your business choices.

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