Employees Take Ownership Through ESOPs, Profit-Sharing Plans

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Getting employees to take ownership in their work is hard. ESOPs and profit-sharing plans put real meaning behind this ask while delivering significant benefits to companies and owners.

September 14, 2022

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It’s not uncommon for managers to push employees to take ownership of their work. The problem is employees are not owners and never will be. Sure, they earn a good paycheck and get incentives for meeting goals, but they don’t reap the financial rewards (or risks) of ownership. So, asking them to act like owners simply doesn’t ring true.

To better motivate employees and to provide for their long-term financial well-being, some companies have turned to employee stock ownership plans (ESOPs) and profit-sharing programs, which reward workers with a piece of the proverbial pie for helping to grow the business and overcome business adversities.

As qualified retirement plans, these programs also provide companies with significant tax advantages and help recruit and retain talent.

HOW THE PLANS WORK. ESOPs and most profit-sharing plans are employer-sponsored retirement vehicles. They share some similarities: All employees who meet eligibility requirements are automatically enrolled in the plan. Typically, employees must have worked for one year (1,000 hours) and are at least 21 years of age. Participants generally are fully vested in the plan after six years.

ESOPs grant actual ownership in a company. The company decides how much stock to share, from a small percentage to 100 percent of the business. Employees are allocated a percentage of available company stock based on their relative pay. If a worker makes 2 percent of payroll, for example, she’d get 2 percent of available shares. (Employees do not buy shares with their own money.)

When a vested employee leaves the company or retires, the company pays fair market value for her shares.

To determine fair market value, ESOP companies have an outside valuation performed each year.

A qualified profit-sharing plan gives employees a cut of company profit for retirement. A company’s annual pre-tax contribution to the plan is discretionary and can be increased or decreased depending on how profitable the company was that year. Employees typically get a percentage of the contribution based on their relative pay.

Companies can have both ESOP and profit-sharing plans. As well, profit sharing can be set up as a non-qualified plan that pays out cash bonuses (minus income taxes).

ESOPs PROVIDE OWNERSHIP, FLEXIBILITY. ESOPs grant employees an ownership stake in a company. In return, company contributions that fund the ESOP are tax deductible, and S corporations don’t pay federal and most state income taxes on the employee-owned portion of the company.

“All those funds you would otherwise pay to Treasury stay in the company and can be used for compensation, buying equipment, capital expenditures, paying off bank debt, so it’s really powerful at the end of the day,” said Tabitha Croscut, an ESOP attorney at Devine, Millimet & Branch, P.A., in Manchester, N.H., who works with companies across the country to implement these plans.

Creating an ESOP helped Assured Environments, a commercial pest control company in New York City, successfully navigate a partner buyout. In 2006, the company took out a “sizable” bank loan to pay off the partner, and at the same time became 23 percent employee owned, explained Andrew Klein, who was president of Assured at the time. This reduced the company’s tax obligation, which helped it pay back the loan, fund the ESOP program and, most importantly, kept key employees from leaving the company.

Some executives were loyal to the partner who left, and Klein feared they might also leave and potentially take clients with them, making it much more difficult for him to pay back the loan.

“By gifting shares to the employees, they were incentivized to grow the company and help pay back the debt right alongside of me,” said Klein.

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These employees stayed on, and when Assured Environments was acquired by Terminix in 2019, all employees vested in the ESOP program received a payout for their shares, same as Klein.

“We had some very happy people. It was a win-win for everybody,” said Klein, who is now vice president of Assured Environments and Terminix business development. Having the ESOP ensured that “everybody who sweated for me” to help pay off the loan and grow the business was rewarded, especially when the company cashed in, he said.

An ESOP shows a commitment to employees. “I do think you attract a better person because they see you’re serious about them and their career path and they want to stay,” said Larry Ryan, founder of Ryan Lawn & Tree, which provides lawn, tree and structural pest control services in six Midwest markets.

The Merriam, Kan.-based company is 100 percent employee owned, which underscores its faith-based culture and mission of caring for employees, family and community. “We want to leave people, even the ones that leave us, better than they were when they joined us,” said Ryan. He feels companies can do better to provide for all employees, not just top management, and the ESOP program helps do this.

Ryan started his ESOP in 1998 to share the company’s success with employees, and by 2019 he had transitioned it to being completely employee owned. Today, 305 employees participate in the ESOP and 130 are fully vested in the program. One employee who worked in the field for 20 years accumulated $895,000 in the company’s ESOP and 401(k) programs. “It makes us feel good because we talked about taking care of people, and in truth, we’re not giving him anything; he’s earned every penny of that,” said Ryan.

ESOPs help employees earn more money for retirement. According to Corey Rosen, founder of the National Center for Employee Ownership, “the mean account balance in an ESOP right now is $134,000. The average 401(k) plan for comparable companies is half that.” More than 6,200 companies in the United States have ESOPs, and more than 3,400 of these companies have fewer than 100 employee participants.

ESOPs also provide a flexible exit strategy. Owners can sell gradually or all at once to an ESOP, which gives them liquidity and more say about their future role at the company while rewarding the people who helped build it. “From the legacy standpoint, this can be really appealing to people,” said Rosen.

In addition, selling to an ESOP is the “most tax-favored way to sell your business,” said Rosen. Owners of C corporations can defer paying capital gains tax on proceeds of the sale if they reinvest those gains in other U.S. companies, such as through stocks and bonds.

“You don’t pay any tax until you sell those investments, where normally you would pay capital gains tax on the sale of the company right away,” he explained. The potential tax savings on selling a $3 million company and reinvesting those gains over 10 years can be worth hundreds of thousands of dollars, he pointed out. As such, an owner can walk away with more money in pocket by selling the company to an ESOP at fair market value than selling it to a third-party buyer for a higher price.

The tax benefit of selling to an ESOP can be even greater for an owner’s heirs. “Right now, based on the tax code, if you keep that investment until death, you’re going to step up in basis at death and no one would ever pay the capital gains tax on your sale,” said Croscut.

ESOP companies, however, need to be consistently profitable to fund the purchase of shares for employees. “The ESOP’s not a bubble” that protects a company from market forces, said Croscut. The company still needs to be successful, financially smart and have good leadership; if the company fails, shares of stock become worthless, and employees get nothing.

Setting up an ESOP incurs legal fees and other costs. As such, they are best suited for companies with 20 or more employees, Rosen said.

PROFIT-SHARING BENEFITS. About 6 percent of pest control companies offer profit-sharing plans, according to a 2022 wage and benefits survey conducted for PCT and the National Pest Management Association. The survey was sponsored by BASF and compiled by Readex Research, an independent survey firm based in Minnesota.

The qualified profit-sharing plan at Lloyd Pest Control in San Diego, Calif., began more than 35 years ago. “For the last three years we’ve made a $1 million contribution to the profit-sharing plan, which works out to 6-8 percent of each employee’s wages,” said Jamie Ogle, the company’s president.

A field employee of 40 years recently retired with $600,000 in his profit-sharing account. “He never put a dime of his own money into that account. It was always put in for him on top of his wages by the company,” said Ogle.

Profit-sharing plans are especially beneficial to hourly workers. “The profit-sharing plan helps provide for their retirement without having something taken out of their wages,” Ogle explained.

For this reason, he chose not to switch to a 401(k) plan, which requires that employees contribute their own pre-tax money to the plan. He said he felt hourly workers would opt out of saving for retirement altogether, preferring instead to have money in hand now to pay for things like higher housing and fuel costs.

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The profit-sharing plan at Terminix Service in Columbia, S.C., is “traditionally ranked as one of the (benefits) that is appreciated the most,” especially by older employees, said Rion Cobb, vice president of human services at the company. For the 2021 fiscal year, Terminix Service contributed more than $1 million to its profit-sharing plan.

The program, which started 50 years ago, shows that the company’s relationship with employees is more than transactional, said Cobb. It goes beyond employees getting paid for work performed today and helping the company be profitable for profit’s sake.

Instead, being profitable means something on a personal level. “You’re sharing in the rewards of the company in a way that becomes very meaningful to people,” said Cobb.

Profit-sharing funds are managed by an investment company on behalf of employees unless they opt into Terminix Service’s 401(k) plan.

Then they can direct how their profit-sharing contributions are invested. Some profit-sharing plans generate the funds that companies use to match employee 401(k) contributions.

Even small companies gain by sharing profit with employees. San Diego-based NixTermite, which has fewer than 20 employees, has an automatic profit-sharing plan and lets employees also contribute their own money for retirement to a Simple IRA.

Both prospective and current employees of NixTermite appreciate the plan. “We believe that this program has helped significantly with our retention as well as attracting new hires,” said Chris Aguilar, who owns the company.

“As a family-owned business, we strongly believe in being committed to the individuals and their families in as much as they have committed their best efforts to our continued growth and success,” he said.

COMMUNICATE THE VALUE. Annual account statements for ESOP and profit-sharing plans are required and remind employees that the benefit isn’t available everywhere.

“If they are paying attention, they’ll do the calculation and see, ‘Oh, if I go to work somewhere else for a dollar more an hour, I’m forfeiting $2,000 from my profit-sharing plan,’” said Ogle.

It’s important to teach employees how their everyday efforts impact the value of these plans. Financial experts say companies would do well to teach their employees how to read financial statements and how reducing expenses and growing the business affects share price or profit, which benefits them personally in the long run.

“We have to explain these things and make sure employees understand how what they do in the company will actually impact their retirement plan,” said Croscut.

Some companies have employee committees to promote these programs. They might hand out pie at lunch to show “we’re sharing a piece of the pie” or hold vesting ceremonies where new, fully vested employees are presented with fleece vests. “It’s getting people engaged and at the same time doing things to educate them,” said Croscut. “You’ve got to have fun when you do it.”

The author is a regular contributor to PCT.