A true employee stock ownership plan (ESOP) is one in which all eligible employees—from rank and file to managers and owners—have a piece of ownership of the company through the ESOP, which only has company stock—except for a little cash—as an investment.

However, with frequent company stock lawsuits against 401(k) plan sponsors and Department of Labor (DOL) litigation regarding company stock purchase transactions, one wonders if sponsoring an ESOP is a good idea.

Mark Kossow, a member at Clark Hill law firm, whose practice is focused on ESOPs, based in Princeton, New Jersey, says retirement plan company stock investment lawsuits are outlier cases. He points out that there is empirical evidence that ESOP-owned companies are more profitable. “The value of the benefit as a retirement plan will be beneficial to employees and employers,” he says.

According to Joanne Swerdlin, executive vice president, Swerdlin & Company, an Ascensus company, who is based in Atlanta, there are more plan assets in ESOP accounts in this country than there have ever been before, and ESOPs are creating more wealth for more people every day. She says the fact that the DOL is litigating certain abuses should give participants comfort that there’s a commitment to effective oversight and getting rid of bad actors in the industry.

Jerry Ripperger, vice president of consulting at Principal in Des Moines, Iowa, says retirement plan advisers don’t provide a lot of services to ESOPs, but they should. He adds that his firm encourages plan sponsors so offer ESOPs as a complement to a 401(k) plan. “Often ESOPs are set up without plan sponsors understanding how to wrap it with their total retirement program. Advisers can come in with plan designs to help employees meet goals. They should be front and center driving the whole retirement plan strategy,” he says.

According to Kossow, an ESOP transaction involves two attorneys—one for the plan sponsor and one for the ESOP. ESOPs also need an independent trustee—that has control over assets and considers buys and sells—as well as an appraiser that works with the trustee to determine what the fair market value of the stock. In addition, a third-party administrator (TPA) or recordkeeper determines benefit allocations to participants and beneficiaries after an ESOP transaction has been made. Plan advisers can help with the selection of all these parties.

Kossow adds that advisers may also provide employee communications to explain how the ESOP works.

In addition to cash within the ESOP that needs to be managed, Swerdlin says the repurchase obligation is a huge concern for an ESOP. There is the risk of not having enough available cash to pay out employees if they become disabled, die, retire or leave the company. There needs to be a plan for funding this liability. This could call for corporate-owned life insurance (COLI) to fund this obligation, or advisers may have other suggestions for helping the company prepare for this future obligation.

Which employers should sponsor an ESOP?

According to Swerdlin, ESOPs operate successfully across a broad range of industries—large and small, public and private. But most ESOPs are established by private companies. She adds that the ideal private company candidate for an ESOP will be one that has strong cash flow and a history of increasing sales and profits, is in a high federal income tax bracket, is not heavily leveraged and has substantial stockholder equity and has capable second-line management in place.

Kossow says business owners with paternalistic feelings for employees are prime candidates for ESOPs. When business owners sell to a third party, that entity may consolidate operations, move the company elsewhere, lay off employees or change the company name. “It could hurt employees. When owners sponsor an ESOP, they have full control of the future of their organization,” he says.

He adds that ESOPs can work well for small, medium or large organizations. “It’s the culture instilled of the pride of ownership that results in the company doing better,” Kossow says.

However, he notes that if the company is too small, it may not be a good candidate for an ESOP. “There are certain rules that if a plan is too small it may be subject to excise taxes, so if a business has fewer than 20 or 15 employees, it should look at whether it is feasible to do an ESOP transaction,” he says.

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