What do Honeywell, Procter & Gamble, Lowe’s and BellSouth have in common? Besides being successful Fortune 500 companies, their leaders at some point made a decision to share that success with their employees through an ESOP (Employee Stock Ownership Plan).
There are approximately 11,500 ESOPs in place in the United States, covering 8.5 million employees who own some stock in the companies they work for. The legislation that encouraged the establishment of ESOPs is part of the Employee Retirement Income Security Act of 1974.
While an ESOP can have its drawbacks — especially if it is not specifically tailored to the company putting it in place, experts say — it can also be a great way to maintain a motivated, bottom-line-oriented work force, as well as provide tax benefits to the company.
The Ruhlin Co., a construction management company based in Sharon Center with an estimated $92 million in revenue, has had an ESOP in place since 1977. When it was established, the plan held 15 percent of the company’s stock. Today, 88 of the company’s salaried employees own 81 percent of Ruhlin’s stock. (The other employees — whose number ranges from 100 to 300 depending on the season — are hourly, unionized workers who don’t qualify for the plan.)
According to company President James Ruhlin, the ESOP’s benefits outweigh any problems that might come along with the plan.
“It’s an excellent vehicle to share the wealth,” he says. “No one person in a company this size makes a company go or not go. They get to share in the rewards of their efforts.”
Ruhlin, who has been president since 1996, says the company’s current ESOP fits with his family’s long-time philosophy of sharing profits with those who have helped make the company a success. Ruhlin’s father, Jack, and uncle, Bill, started a profit-sharing program in the 1960s, before ESOPs existed.
The Ruhlin Co.’s ESOP is set up so that shares in the company are distributed yearly to employees. Those shares are allocated to individual employee accounts within a trust account, and cannot be disbursed until an employee retires or otherwise leaves the company, after a vested amount of time.
The shares’ value depends on how well the company performs, and typically, the stock must be valued by an independent appraiser before shares are put into the ESOP.
“The ultimate benefit to the company is that you have employees who have a financial interest in the company, other than just a paycheck,” Ruhlin says. “When people know they’re going to own a piece of the pie, it’s going to make a difference.”
Ruhlin says the ESOP gives him a competitive advantage when it comes to luring qualified workers in an industry that has “typically not been popular with the younger generation.”
Only about 10 percent of companies in the construction industry have ESOPs in place, he says.
“It gives us an advantage in our hiring ability.”
But while an ESOP has its advantages, it’s critical that company leaders put certain programs in place to help employees understand how the plan works and what their rights are as stockholders, advises Steve Clem, program coordinator for the Ohio Employee Ownership Center at Kent State University.
“When you go into one of these things, management has to be careful not to oversell,” says Clem. “If this is something that management wants, and they want the employees to go along with, they have to be careful not to oversell and have people thinking that they’re going to have input on every little decision that comes down the pike — because that doesn’t happen.
“Sometimes it’s sold as though you’re going to be in charge, and you can fire the supervisor that’s been treating you badly all these years — it isn’t how it works,” Clem says. “It runs just like a regular company, except that the employees who are part of the ESOP have an opportunity to have some input and to accrue an extra benefit.”
Ruhlin agrees difficulties can arise when employees take the word “ownership” literally and falsely assume they can make direct decisions about how the company is run.
“The hardest part is that when you use the term ’employee owner,’ the word ‘owner’ carries a connotation in peoples’ minds that they run the place,” he says. “That’s not always a negative thing, but they are really a stockholder. You get all the rights of a stockholder, but not an owner.”
Ruhlin says at The Ruhlin Co., shareholders elect the seven-member board of directors, which then makes executive decisions such as appointing the company president.
“People need to understand that an effective board provides advice to management — it’s not an employee watchdog group,” he says.
Ruhlin, an engineer, was hired by the board six years ago to run the company, after it decided he was the best candidate for the job, regardless of his family name.
“I had to pass that test, or I’d just be a Ruhlin,” he says.
His performance is evaluated by the board every year, and while he is the third generation of Ruhlins to run the company, there is no guarantee that a Ruhlin will always occupy the corner office. (Prior to 1996, a nonfamily member ran the company for two years.)
Ruhlin says some of the complications of an ESOP can be worked out through ongoing education of employees and management. As a member of KSU’s Ohio Employee Ownership Center, Ruhlin participates in roundtable discussions with leaders of other ESOP companies, and Ruhlin’s employees attend training classes.
When asked if he would recommend the ESOP structure to other businesses, he says only if it fits the needs of the ownership and is carefully crafted.
“We’re basically a private company, but I’ve had to learn to run the company as a public company,” he says. How to reach: The Ruhlin Co., (330) 239-2800; Ohio Employee Ownership Center at Kent State University, (330) 672-3028 or www.kent.edu/oeoc
Tax incentives
Congress has granted a number of specific incentives meant to promote increased use of the ESOP concept.
Deductibility of ESOP contributions
As with all tax-qualified employee benefit plans, contributions to ESOPs are tax deductible to the sponsoring corporation up to certain limits. Contributions can be either in cash (which is then used by the ESOP to buy employer securities) or directly in the form of employer securities.
When employer securities are contributed directly, the employer may take a deduction for the full value of the stock contributed.
The deductibility of contributions to an ESOP becomes even more attractive in the case of a leveraged ESOP. Under this arrangement, an ESOP takes out a cash loan from a bank or other lender, with the borrowed funds being paid to the sponsoring employer in exchange for employer securities.
Since contributions to a tax-qualified employee benefit plan are tax deductible, the employer may thereafter deduct contributions to the ESOP which are used to repay not only the interest on the loan, but principal as well.
This makes the ESOP an attractive form of debt financing for the employer from a cash flow perspective. Each year, the company can deduct contributions of amounts up to 25 percent of the covered payroll, plus any dividends on ESOP stock, which are used to repay the loan.
Any contributed amounts used to repay interest on the loan are deductible without any limit.
ESOP rollover
An additional incentive allows a shareholder, or shareholders, of a closely held company to sell stock in the company to the firm’s ESOP and defer federal income taxes on the gain from the sale.
To qualify for this “rollover,” the ESOP must own at least 30 percent of the company’s stock immediately after the sale, and the seller(s) must reinvest the proceeds from the sale in the securities of “domestic operating corporations” within a year. The seller, certain relatives of the seller, and 25 percent shareholders in the company are prohibited from receiving allocations of stock acquired by the ESOP through a rollover.
Deductibility of Dividends
Employers are also permitted a tax deduction for cash dividends paid on stock which has been purchased with an ESOP securities acquisition loan, to the extent that the dividends are passed through to the employees. The dividends are taxable as current ordinary income to employees.
A deduction is also available for dividends paid on ESOP leveraged stock to the extent that the dividends are used to reduce the principal or pay interest on an ESOP loan incurred to buy that stock. Source: The ESOP Association, www.esopassociation.org
