A Q&A with Alex Mumblat

What is employee ownership and what are the main benefits?

Employee ownership is a broad concept that can take many forms, from granting company shares or profit sharing to highly structured management incentives. What all of these different instruments have in common is that they offer employees the opportunity to benefit directly from the company’s financial success.

The most common form of employee ownership in the United States is the Employee Stock Ownership Plan (ESOP), a highly tax-efficient retirement plan in which employees own stock through a company-owned trust. ESOPs are often used by limited liability companies as a business transfer tool. In these cases, a company sells some or all of its issued stock to an employee trust at fair market value.

Employee ownership plans are also commonly used to attract and retain employees. Plans provide long-term wealth-building opportunities and foster a high-engagement work culture that directly motivates employee ownership.

How is an ESOP different from other qualified employee benefit plans?

Qualified retirement plans are employer-sponsored plans that meet the requirements of the Internal Revenue Code (IRC) and the Employee Retirement Income Security Act (ERISA). These plans are eligible for certain tax benefits, such as tax deductions for contributions and tax deferral on investment income.

The two main categories of qualified retirement plans in the U.S. are defined benefit plans and defined contribution plans. ESOPs and 401(k)s fall into the category of defined contribution plans, where employers, employees, or both parties contribute a set amount to fund individual retirement accounts.

What makes an ESOP unique is that these plans invest exclusively in the stock of a sponsoring company (using employer contributions). In this way, a plan helps align the interests of all stakeholders (company, shareholders, and employee owners) and creates a strong incentive to create value.

When an employee leaves an ESOP company, the company is expected to “open a market” and buy back their shares. The exact timing of these buybacks depends on the specific design of the company’s ESOP plan. While payouts for buybacks can be deferred for younger employees, retirees typically receive their full benefits relatively quickly.

What disadvantages can employee participation bring?

One potential risk is that an ESOP invests only in stock of one plan sponsor. This can create additional risk for plan participants if their company’s performance declines. Therefore, it is important for employee owners to continue to participate in other available retirement savings options that provide additional diversification, such as a 401(k). Under certain conditions, plan participants may be allowed to diversify their ESOP accounts – initially up to 25% of the account value and eventually up to 50% into various publicly traded securities.

There are also several misconceptions about ESOPs. These include: “rank-and-file employees will run the company” (an employee-owned company is run by its management team under the supervision of the board of directors) and “employees will have access to confidential company information” (participants will receive annual plan statements, similar to other retirement accounts, but additional open-book management procedures are not required).

How does a company’s benefits program change when an ESOP is established?

In most cases, there are no significant changes. Most of our corporate clients who sponsored 401(k) plans prior to the implementation of an ESOP retain those plans after the transaction. Occasionally, companies suspend or reduce matching contributions but continue to allow employees to make deferred contributions.

IRC Section 415 limits the amount of annual contributions an employee can receive from all defined contribution plans. This amount is capped at $69,000 for 2024 and therefore applies primarily to highly compensated employees. Those affected by this limitation must decide how to allocate their benefits (e.g., maximizing ESOP stock awards at the expense of 401(k) deferrals or vice versa).

What role does an HR/Benefits team play in implementing and managing a successful ESOP?

A company’s human resources department is often involved in the ESOP design process. They can play an important role in aligning plan design with a company’s broader benefit offerings. Initial plan communications – including formal transaction announcements and distribution of summary plan descriptions (SPDs) – are typically coordinated by the same professionals.

Once the contract is signed, the HR team’s job is two-fold. There is a technical side that includes interfacing with the ESOP’s third-party administrator (TPA). A TPA must receive accurate census data in a timely manner to prepare annual participant statements of the plan.

Second, HR professionals can help promote the cultural elements of an ESOP. This includes educating employees, promoting the benefits of the plan, and answering questions about various plan features. Team members should also monitor plan adoption and related performance metrics. This may include employee awareness and understanding, as well as the effectiveness of the plan as a motivational and retention tool. Plans may change from time to time, and a well-coordinated HR team can greatly improve this process.