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ESOP Pitfalls and How to Avoid Them

Posted by Corey F. Schechter | Aug 04, 2017

There are a number of benefits associated with employee stock ownership plans (ESOPs) for companies. In general, an ESOP can be a benefit to owners, employees, and the company overall. However, ESOPs can present some problems and complications. Understanding the potential pitfalls of an ESOP can help employees and business owners avoid them.

An ESOP creates a trust for employees as plan participants to own a right in the company stock. Eligible employees are given an interest in employer securities as a benefit of working for the company. ESOPs provide tax benefits for the company and business owners.

For the stockholders and business owners, the benefits of an ESOP include having a ready buyer for fair market value, the ability to reasonably transition the company from private ownership to employee ownership, and deciding how much of the company the owner wants to retain.

For employees, the ESOP allows them to take an ownership interest in their job. They have a financial interest that goes beyond the paycheck and benefits from the company's long-term success.

One potential problem involves the company's valuation. In some cases, business owners have sold company stock to employees at an inflated value. This can cause the ESOP to borrow more money than the company can afford. Generally, an active and experienced fiduciary will prevent an ESOP from overpaying for company stock. However, another potential problem involves trustees who are not fulfilling their fiduciary duty to ensure the ESOP pays no more than adequate consideration for the shares purchased from the company.

Like other plans that fall under ERISA, trustees owe a fiduciary duty to act solely in the best interests of plan participants and beneficiaries. In an ESOP, the trustee may be responsible for determining the value of company stock. Failure to act in the participants' best interests can reduce the value of the company stock or waste plan resources.

An ESOP may not be the best option for all companies. Smaller companies may not always have the resources to administer an ESOP. ESOPs can be complex, requiring administrative, legal, and compliance costs. Trustee costs and fees can drain a small company of cash, leaving loans that can exceed the reduced value of the company.

Selling to an ESOP may be a great option for a company that may be difficult to sell to a third-party. However, with an attractive and competitive company, a sale on the open market may bring the owners a higher sale price than the valuation provided to an ESOP.

An ESOP is an eligible individual account plan and falls under ERISA. This requires compliance with ERISA, including fiduciary duties and notice requirements. ERISA violations give plan participants legal recourse, possibly exposing the trustee or plan administrators to ERISA liability.

Before transitioning your company to an ESOP, make sure you understand the risks, as well as the benefits. If you have any questions about the pros and cons of employee stock ownership plans for your company, the law firm of Butterfield Schechter LLP is here to help. We are San Diego County's largest law firm focusing its law practice on employee benefits law. Contact our office today with any questions on how we can help you and your business succeed.

About the Author

Corey F. Schechter

Corey Schechter practices in the areas of Employee Benefits, Employee Stock Ownership Plans, Pension and Profit Sharing Plans, ERISA, ERISA Litigation, Business Law, Qualified Domestic Relations Orders (QDROs), and Employment and Labor Law.


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