Some tax benefits differ between S- and C- corporations, but other benefits include deductibility of a portion of contributions made to an ESOP and of dividends paid on ESOP-held stock. According to the NCEO, an ESOP also allows a company to use pre-tax dollars to buy out the owners, and sellers can defer capital gains taxation on the sale proceeds. Employees do not pay tax on stock allocated to their ESOP accounts.
Making It Work
Becoming a 100 percent ESOP is not without its challenges and carries risk.
Why? Well, any investor in any security is at risk. In this case, the investors are the employees. “Our associates are at risk if we don’t execute well,” Cross says. “We can harm our stock value and their retirement.” Without strong cash flow, it may be difficult to meet redemption requirements as workers retire.
“It’s a tough business out there in industrial distribution we’ve continued to find ways to diversify the company and have used acquisition strategy as part of that to keep growing the company in a manufacturing economy that is downsizing,” Cross says.
It is also expensive to set up an ESOP, costing anywhere from $20,000 for a small company and up from there.
To ensure continued growth, and support an ESOP, Cross says it’s crucial to empower your employees.
“We’ve got great management teams. They walk the talk about employee ownership. They are astute in their own right,” Cross says. “We have four business units, each with their own capable management team that writes their own strategic plans and develops their own budgets. And so as opposed to a centralized organization, we decentralized the business units. They have that sense of empowerment.”
Cross Company has divisional offices in Greensboro, NC, Belmont, NC, and Conyers, GA, and six other customer service facilities. Its business units are: Cross Fluid Power, Cross Automation, Cross Instrumentation, and Cross Hose & Fittings. It operates in southeastern U.S.
“Even though we have an external Board of Directors and I’m delighted that we do they also have the wisdom to stay at 25,000 feet and only involve themselves in the most significant corporate affairs,” Cross says. “We’ve executed well over time and developed good people. … It’s rare that we hire management from outside the company.”
On its Web site, the NCEO provides these basic steps for setting up an ESOP:
- Determine whether all owners are amenable to a partial or full buyout.
- Conduct a feasibility study.
- Conduct a valuation of the business.
- Hire an ESOP attorney.
- Obtain funding for the plan.
- Establish a process to operate the plan.
Contact your advisers on whether an ESOP will work for your company, and, if it will, how to implement it correctly.
National Center for Employee Ownership, http://www.nceo.org/
ESOP Association, http://www.esopassociation.org/
Here’s a look at Cross Company’s recent decision to go 100 percent employee-owned. Employee Stock Ownership Plans partial or full carry both benefits and risks, but can be a viable exit strategy or a way to provide additional benefits to your workforce. Weigh the ups and downs carefully with advisers before moving forward.
Only consider an Employee Stock Ownership Plan (ESOP) if you are growing and have strong cash flow. That’s the advice from an ESOP-experienced Pete Cross, CEO of industrial distributor Cross Co., which has run a partial ESOP for 28 years.
Cross Co., Greensboro, NC, which distributes motion control and factory automation products, recently moved to a 100 percent ESOP and is now fully owned by its 195 employees.
What It Is
According to the National Center for Employee Ownership, an ESOP is an employee benefit plan operated through a trust that accepts tax-deductible contributions from the company to accumulate company stock, which is then allocated to individual employees.
ESOPs are used to buy the shares of an owner, to borrow money at a lower after-tax cost, or to create additional employee benefits. The ESOP can acquire both new and existing stock; the trust can borrow money to buy the stock, with the company repaying the loan by making tax-deductible contributions to the ESOP, according to NCEO.
An owner looking for an exit strategy may consider an ESOP to avoid selling the business to an outsider.
An ESOP seems to be a somewhat popular option among manufacturers and distributors. The nonprofit ESOP Association reports that about 28 percent of its members are in manufacturing, followed by construction and distribution at 13 percent. About 71 percent of Association members have less than 250 employees.
A 2006 survey by the ESOP Association showed that 91 percent of respondents agreed that creating employee ownership through an ESOP was a good decision that has helped the company.” In addition, 72 percent of those respondents indicated financial performance has been superior to stock market benchmarks.
Since Cross Co. implemented its plan in 1978, sales have risen five-fold and stock value has grown at a compound growth rate of 10.3 percent, or slightly more than the S& P 500 over the same time period.
Cross Co.’s founder, William S. Cross Jr., implemented the ESOP in 1978, starting at 40 percent employee ownership. Over the years, by buying shares from individual stockholders, the company transitioned to 60 percent ESOP, and then recently went all the way. The ESOP was originally set up to buy out the founder’s shares, says Pete Cross, his son.
“The decision to complete the transition was carefully considered over 18 months of rigorous analysis and thoughtful deliberation,” Cross says. Cross says his company had three reasons to go 100 percent employee-owned.
The first: Redemption obligations with a mature ESOP are a growing issue. As employees retire, or as they diversify their ESOP accounts, the company must have cash to satisfy those demands.
The second: The company had two bodies of shareholders internal shareholders through the ESOP and external stockholders (family members, original investors and former employees). The Board of Directors was increasingly challenged by what was in the best interest of both of those groups. “We knew as a closed corporation that sooner or later we would have to provide a market for those (external) individual shareholders to one day sell those shares. We knew that was looming out there.”
The third: Companies that are 100 percent employee-owned and are S-corporations Cross Company’s outcome receive significant tax advantages. A 100 percent ESOP S-corporation pays no taxes on corporate earnings, which improves cash flow. (Some states’ tax regulations may vary on