ESOP Blog

By Ronald J. Gilbert & Corey M. Rosen

In 1987, WesRay, an investment firm led by former U.S. Treasury Secretary Bill Simon, a man of considerable financial acumen, sold AVIS to the AVIS Employee Stock Ownership Plan (ESOP). In addition to being attracted by a major new tax incentive that had just been enacted to encourage owners to sell their stock to an ESOP, Mr. Simon was optimistic that the new employee owners would identify as such.

Several years later an AVIS car was stolen from an AVIS lot in broad daylight. An AVIS employee owner jumped into another car and was able to force the thief over to the side of the road and keep him there until police arrived. “Why did you do that!?”, an incredulous police officer asked. “That was dangerous!” “He stole my car,” was the reply from the AVIS employee owner. (Avis was sold in 1996 for almost three times what the ESOP paid for it).

Focused Identification
Focused identification as an owner was vividly brought to my attention in October of 1989 in Warsaw, Poland. Kris Ludwiniak and I had just begun our efforts to privatize Polish state-owned enterprises and make them employee owned. In Warsaw’s Central Square we met with the employees of a company that manufactured replicas of antique furniture. After briefly explaining how the employee stock ownership program would work, an older employee in the front row stood up and said “They told us we owned everything, we learned that we owned nothing, and now we want to own something.”

(Note: Using Louis Kelso’s concept of access to capital credit, approximately 1,000 Polish state-owned enterprises were successfully privatized and became 100% employee owned.)

Why Do U.S. ESOPs Work So Well?
Forty years of extensive research in the U.S. has demonstrated that ESOP companies improve job security and are three to five times less likely to lay off employees depending on the study year. ESOPs fare better during economic downturns. During the COVID-19 pandemic, ESOPS were nearly four times more likely to retain jobs. During the Great Recession, employment grew by 1.9% among ESOPs while it fell by nearly 3% overall. ESOPs improve retirement security. 60 – 64-year-old employee owners had, on average, approximately ten times greater wealth than their peers. National Center for Employee Ownership research shows that controlling for size, industry, and region, the average ESOP participant retirement balances were about two times, or $67,000 higher than the comparison group in non-ESOP companies that had retirement plans (about twice as high). If that weren’t enough, ESOP companies also perform better than their peers, and ownership remains in the local community.

Research
It is essential to note that the research cited above refers to U.S. Employee Stock Ownership Plans (ESOPs), a qualified retirement plan under the U.S. Employee Retirement Income Security Act, ERISA, which was enacted in 1974. The term employee ownership is widely used, and can refer to numerous employee ownership models. What is essential to note is that the research cited above, was specific to the ESOP, and primarily conducted by independent entities. The ESOP research does not apply to other forms of employee ownership that are cousins in terms of their relationship to the U.S. ESOP. The independence of any research on these other forms of ownership should be firmly established to insure credibility.

My 46 years of experience which began working with Louis Kelso has led me to the following conclusions as to the top ten essential aspects that are responsible for the stellar ESOP company performance cited above.

1. Allocated account. ESOP participants have an individual account within the ESOP which states the number of shares allocated to their account, the current value of the stock, (determined annually by an independent appraiser), the number of shares that are vested, and any “other investments” in the ESOP account.
2. Vesting. ESOP accounts must have a vesting schedule, with 100% vesting required after 6 years of service. Vesting is accelerated to 100% in the event of death, disability or retirement. ESOPs, can, and should, give employees full past service credit for vesting.
3. No Employee Investment. Approximately 99% of ESOPs in privately-held companies do not require any employee investment. It is also rare for the ESOP to be combined with any wage reduction.
4. Independent Valuation. ESOPs are required to have an annual independent valuation of the company.
5. Trustee. ESOP stock is held in trust. The trustee of the ESOP has a fiduciary duty to act for the “exclusive benefit of plan participants and their beneficiaries”.
6. Yearly Payouts Timetable. The ESOP payout timetable is defined and there is a time limit on the installment period. Payout of the full account must begin upon death, disability, retirement or other termination of service, the payment can be deferred for up to 5 years. All ESOPs must offer a diversification option for employees 55 or older with 10 years of service, and some plans offer an earlier diversification option.
7. Tax Benefits.
   a. Income attributable to stock owned by an S corporation ESOP is tax free from federal and most state taxes.
   b. All assets in the ESOP account grow on a tax deferred basis and are only taxable to recipients upon payout.
   c. Some selling shareholders to C corporation sponsored ESOPs are eligible to defer capital gains tax on the sale and in many instances make the deferral permanent.
8. Clear and Consistent Communication about the ESOP. Over time with clear and ongoing communication more and more employees “think like owners” and understand that the ESOP is a very significant wealth building opportunity.
9. Job Level Input. While there are many corporate governance structure options for ESOP owned companies, research demonstrates that job level input is essential to maximize the effectiveness of the ESOP. Once an employee identifies as an employee owner, that person frequently wants to make things better. The company must provide structures to use valuable employee input. Communications committees are one proven way to accomplish this.
10. Rigorous Research. Decades of rigorous research by The National Center for Employee Ownership, Rutgers University, The Employee Ownership Foundation, and others have demonstrated that ESOPs excel in good times and have remarkably higher survival rates in bad times, as noted earlier. This has convinced lawmakers across the political spectrum to become strong ESOP supporters.

What Isn’t Required
One unique aspect of ESOPs is that they give employees a long-term incentive. Account details are reported annually to track the appreciation of their individual ESOP account. Combining the ESOP with short term and midterm compensation will maximize employee performance. What is not required is the sale of the company. As cited earlier, one of the advantages of U.S. ESOPs is promoting local economic prosperity. Plans structured that only can reward employees if the company is acquired are contrary to this long-term goal. While many ESOP companies have been acquired, it is a voluntary decision made by the company’s board of directors and owners. Many ESOP companies have been successfully operating for 20 years or more, and there are those like ComSonics, Inc. that is celebrating its 50th anniversary of an employee-owned company.

Comparing ESOPs to Other Employee Ownership Plans
There are two relatively new types of employee ownership plans that warrant attention. First is the Employee Ownership Trust (EOT), first introduced a decade ago in the U.K. and more recently in the U.S. The EOT has become very popular in the U.K. but has had, and I expect will continue to have, limited applicability in the U.S., in great part because the U.S. EOT does not provide direct share ownership or any tax advantages. Smaller less profitable companies will find the lower cost of the EOT attractive.
It should be noted that EOTs as structured in most U.K. plans are not employee ownership in the traditional meaning of that term. Employees do not have any equity claims on the company. This may change the way employees think about the company and how it chooses to invest money for growth versus a profit payout, and may encourage a sale down the road unless the EOT is structured so that sale proceeds go to some other purpose. The new Canadian EOT law stipulates that on the sale of the company, proceeds have to be divided up among current and possibly former employees.
The second plan is sometimes referred to as the PE (Private Equity) model. Championed by KKR and the nonprofit Ownership Works, and with other PE firms also announcing their intention to provide an employee ownership benefit, these plans offer employees the possibility of a payout, which could be substantial, but only upon the sale of the company. The plan usually allows the benefits to be provided to most or all employes, but could be limited to senior staff. Since the classic PE model calls for the company to be sold within a relatively short period of time, 5 to 7 years, this model, like the EOT, has limited applicability. It is only available to those employees who work for a company acquired by a PE firm, and it is by definition a short, or at best, mid-term incentive plan that allows employees to share in the company sales proceeds.
While EOTs and the PE model have the potential to provide cash payouts to employees, often only upon the sale of the company, they are very different from the ESOP as the accompanying comparison tables provided by Corey Rosen illustrate.
That said, the identifiable stock ownership communities and proponents in the U.S. and U.K. should look for ways to collaborate with these relatively new additions to the employee ownership family in order to advance the cause of broadened employee ownership.

U.S. ESOPs In the U.K.?
U.S. ESOPs have performed incredibly well over the past 50 years, and have many unique aspects not available in an EOT or in other forms of employee ownership in the U.S. and U.K. Can a way be found to allow U.K. employees to participate in a U.S. ESOP on a tax deferral basis? A tax treaty idea has been referenced in a new report by Rutgers University and recently discussed at the International ESOP Conference at Oxford University that could provide a roadmap for this to occur.

Tax Treaty
Lawmakers across the political spectrum in both the U.S. and the U.K. support broad-based employee ownership. U.K. laws are enacted, in the case of employee ownership, through His Majesty’s Revenue and Customs (HMRC). The IRS has an oversight function for U.S. ESOPs. A tax treaty may only need the approval of the IRS and HMRC. Since numerous U.S. companies operate with U.K. employees who are taxed as U.K. citizens, a tax treaty could provide a tax exemption for the allocation of stock in the U.S. based company’s ESOP to the account of the participating U.K. citizens, and any tax would be deferred until the stock account is cashed out under the rules of the U.S. ESOP. While many countries do not tax the stock allocation until it is cashed out, the U.K. does impose a tax on the stock allocation at its inception.

”Road Map” Private Letter Ruling
In 2014 the IRS issued a ground breaking Private Letter Ruling (PLR) defining the terms under which citizens and tax payers of other countries could participate in the U.S. company’s ESOP. The IRS should be able to utilize this PLR for the tax treaty.

RONALD J. GILBERT – President and Cofounder

Ronald J. Gilbert (“Ron”) is cofounder with Susan Gilbert, and President of ESOP Services, Inc., an international consulting firm specializing in Employee Stock Ownership Plan (“ESOP”) transactions for privately held companies. With offices in Virginia, the firm’s clients are in a majority of the U.S.

Ron holds a Bachelor’s Degree in Commerce from the McIntire School of Commerce at the University of Virginia and a Master of Financial Services from The American College. He served on The ESOP Association’s Board of Directors and its Legislative and Regulatory Advisory Committee, and served on the board of directors of eight ESOP companies. He is a former member of the board of directors of The National Center for Employee Ownership.

With over forty years of experience, Ron is a frequent speaker at ESOP seminars sponsored by The World Bank, The ESOP Association, The National Center for Employee Ownership, banks, colleges, national and state governments, etc., and has spoken in nine countries. Ron was instrumental in obtaining the first IRS private letter ruling sanctioning an international ESOP for a U.S. based company.

Ron Gilbert is co-author and co-editor of Employee Stock Ownership Plans: ESOP Planning, Financing, Implementation, Law and Taxation, the most comprehensive work on the subject, published by the Beyster Institute. He has also authored numerous ESOP articles for various publishers, including the Brookings Institution Press and The National Center for Employee Ownership. Publications include the Journal of Employee Ownership, Law and Finance; Don’t Do That; and Selling to an ESOP.

COREY ROSEN

Corey Rosen is the founder of the National Center for Employee Ownership in the U.S. He co- authored, along with John Case, Ownership: Reinventing Companies, Capitalism, and Who Owns What (Berrett Kohler, 2023). Over the years, he has written, edited, or contributed to dozens of books, articles and research papers on employee ownership. He has been called the leading expert on employee ownership in the world. He has been interviewed widely by major media and spoken around the world.

Corey received his Ph.D. in political science from Cornell University in 1973, after which he taught politics at Ripon College in Wisconsin before being named an American Political Science Association Congressional Fellow in 1975. He worked on Capitol Hill for the next five years, where he helped initiate and draft legislation on ESOPs and employee ownership. In 1981, he formed the NCEO. He serves on several ESOP company boards.

See the original version of this article here.

ESOPs ended up under ERISA, not by design, but because the legislative father of the ESOP Senator Russell Long was able to seize upon the extraordinary legislative opportunity to add ESOPs to the much larger pension reform bill. One consequence was that the Department of Labor (DOL) ended up sharing oversight functions for ESOPs with the IRS.

The IRS, with a few exceptions, has performed its role as an objective watchdog agency, going after the bad guys when violations were discovered, such as its pursuit of S ESOP scams. In contrast the DOL, motivated by its ideologized opposition to undiversified retirement plans, which began in the 1970s, promulgated ESOP policies that have significantly thwarted ESOP growth, and have often alleged abuses that were not supported by objective facts and/or extended investigations for periods exceeding 3 years. The Bowers + Kubota litigation is the most recent egregious example.

ESOP Future

For ESOPs to have the future robust growth that their stellar record supports, major changes are required in the near-term future. At the top of the list are:

1. New DOL adequate consideration regulations are needed with specific safe harbor “best practice” procedures.
2. Fiduciaries and board members, management and others deemed to be functional fiduciaries need to be insulated from class action law suits by following the “best practice” procedures referred to above.

I believe that without these changes employee ownership through ESOPs will experience decline. More and more owners and companies will be unwilling to subject themselves to the risk of DOL harassment and litigation and class action litigation. Some ESOPS have been and will continue to be replaced by other forms of employee ownership that do not offer employees nearly the same well-defined and protected benefits. Two recent examples that surfaced in the past decade are Employee Ownership Trusts (EOTs) and the private equity (PE) model now being used by a number of the largest M&A firms. While both of these models offer the possibility of significant payouts to most or all of the employees of the company, their applications are limited.

For fifty years ESOPs have uniquely provided employees with stock ownership they can and do identify with, enabling them to think like owners. This identifiable ownership, fueled by significant tax benefits, is sorely needed in today’s economy. ESOPs enjoy strong bi-partisan support, a rarity in today’s polarized legislative environment. Congress needs to take rapid and decisive action to protect and grow this unique broadened ownership program.

Ron Gilbert has been providing ESOP consulting work since the 1970s, where he began his ESOP career working for Louis Kelso, and was one of the first ten NCEO members.

Read original article here.