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For many business owners, the question: “Who will own my business when I’m ready to step away?” is very much top of mind.
A third-party sale can provide liquidity, but it may also mean giving up the company’s independence, culture, and legacy. Family succession isn’t always an option, and a management buyout can present its own financing challenges.
Employee ownership offers another path.
Two structures that business owners may consider are:
- Employee Stock Ownership Plans (ESOPs).
- Employee Ownership Trusts (EOTs).
Both keep the business independent and share its success with the workforce, but they differ sharply in cost, tax treatment, and what the employees receive.
Which structure may best fit the owner, the business, and the desired outcome?
ESOP: Powerful, but built for scale
An ESOP is a federally regulated retirement plan that holds company stock for the benefit of employees. Employees generally accumulate an interest in the company tied to shares held by the ESOP trust.
For qualifying transactions, an ESOP can offer significant tax advantages. For example, certain owners of C corporations may be able to defer capital gains when selling at least 30 percent of the company to an ESOP under Section 1042 of the Internal Revenue Code. Note that the 30 percent threshold is one of several requirements under Section 1042. Contributions used to repay acquisition debt are deductible, so the company effectively buys out the owner with pre-tax dollars. And an S corporation owned 100 percent by an ESOP generally pays no federal income tax on its earnings, but participants are generally taxed when benefits are distributed.
However, those advantages come with complexity and cost.
ESOP transactions typically involve substantial legal, valuation, financing, and regulatory requirements. As a result, they generally take longer to set up. The company also takes on the ongoing administration and fiduciary responsibilities of the plan.
For businesses with sufficient scale, profitability, and management depth, an ESOP can provide a powerful combination of owner liquidity, employee ownership, and potential tax efficiency.
EOT: Simpler, flexible and mission-focused
Rather than creating a retirement plan, an EOT establishes a trust that owns some or all the company’s shares for the long-term, collective benefit of the employees. Employees generally don’t receive individual ownership like they do under an ESOP. Instead, the trust can be structured to provide employees with economic benefits through profit distributions or other arrangements.
The appeal is flexibility. Unlike an ESOP, an EOT is generally not structured as an ERISA-qualified retirement plan. There's no repurchase obligation, and the trust can be drafted to protect the company's mission and create meaningful barriers to a future sale. Costs are meaningfully lower, making EOTs viable for companies too small to justify an ESOP.
The trade-off is taxation. EOTs generally don’t provide the same tax advantages available to ESOPs. Sellers get no Section 1042 deferral, and the buyout is typically funded through a seller note repaid from after-tax cash flow. In addition, certain EOT structures may not qualify as permissible S corporation shareholders, so an EOT sale may make a C corporation structure or another arrangement necessary. This issue to should be reviewed carefully with tax counsel.
So why might an owner consider an EOT?
If tax savings isn’t the only objective, then an EOT deserves a closer look. For some owners, the ability to shape the future of the business may be just as important as maximizing the financial value of the transaction.
For those owners, an EOT may be worth exploring because it can:
- Preserve the company’s independence and culture.
- Help the business remain employee-owned for the long term.
- Provide flexibility in how employee ownership and governance are structured.
- Reduce costs and administrative requirements.
- Avoid leaving future leadership with a repurchase liability.
Making the ESOP/EOT decision
The first step is to determine your exit objectives.
The choice between an ESOP and an EOT shouldn’t begin with the structure. It should begin with your vision for the next chapter of the business. When deciding between the two options, ask yourself these questions:
- How much liquidity do I need?
- How important are tax efficiencies?
- Do I want the company to remain independent?
- How should employees participate in the value they help create?
- Is there a management team capable of carrying the business forward?
- What do I want the company to look like five, 10 or 20 years after I leave?
Those answers can help determine whether an ESOP, EOT or another succession strategy deserves further consideration. Owners should bring in their financial professional or advisor, CPA, an attorney experienced in employee ownership, and a qualified appraiser early, and model all structures before committing.
Ultimately, employee ownership isn’t one-size-fits-all. The goal is to find the ownership structure that aligns the owner’s financial objectives with the company’s future and the people who will carry it forward.
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Frequently Asked Questions about ESOPs and Employee Ownership Trusts
Q. What is the main difference between an ESOP and an EOT?
A. An ESOP is a federally regulated retirement plan that gives employees individual ownership through company stock accounts, while an EOT is a trust that holds shares collectively for employees' benefit without individual accounts. ESOPs offer significant tax advantages; EOTs offer simplicity and flexibility at lower cost.
Q. Which offers better tax benefits, an ESOP or an EOT?
A. ESOPs generally offer stronger tax advantages, including potential capital gains deferral under Section 1042 for C corporation owners and tax-deductible contributions. EOTs in the United States do not currently provide these same tax incentives, so the buyout is typically funded with after-tax dollars.
Q. Can a small business use an ESOP?
A. ESOPs involve substantial legal, valuation, and administrative costs, so they typically suit larger, profitable companies with management depth. Smaller businesses may find an EOT more viable because set-up and ongoing costs are meaningfully lower.
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