Newsletter Article
December 2023

Creative Approaches to Ownership: Putting Ownership Back in Employee Ownership Trusts

There has been growing interest in the US in employee ownership trusts (EOTs). In an EOT, a special purpose trust purchases all or part of the shares from sellers. The trust is designed to be permanent so that the company does not become a target for acquisition.

EOTs are the main form of employee ownership in the UK, largely because sellers can exclude gains from selling to an EOT from taxation. In the UK, there are rules for employee eligibility and allocation meant to make these plans inclusive. In the US, EOTs do not have any special tax benefits, and companies can set up whatever rules they want for how employees participate in the trust. Like ESOPs, sales to EOTs can be funded by bank loans, seller notes, or both.

A few dozen EOTs have been set up in the US, mostly in companies with fewer than 100 employees. While some companies choose an EOT because of the flexibility of the rules or because, unlike in an ESOP, fiduciary rules cannot compel a sale to another buyer, the main appeal of EOTs is that they are relatively inexpensive to set up and less complicated to administer. That is what drew Joe Nussbaum of ACP International to an EOT. Nussbaum told our Fall Forum that he was concerned that his company, a manufacturer of signs and labels, did not have the people to handle the complexity of an ESOP on an ongoing basis. He also found that the lower costs and simplicity of the structure offset any tax benefits the ESOP might provide.

In an EOT, employees receive a share of the company profits, either as conventional profit sharing or a dividend based on an allocation formula the company creates. Unlike in an ESOP, however, the employees have no claim on equity. When they leave, they do not have any shares to cash in. If the company is sold, however, employees there at the time would divide up the proceeds. This has raised concerns in the UK that there could be pressure to sell at some point. That could be beneficial to people there at the time, but would not help those who left before the sale—the same employees who helped repay the acquisition loan. Not having ownership also does not address a key issue ESOPs were designed to address—the substantial wealth insecurity most workers now face.

Finding Solutions

Fortunately, this is not a difficult problem to solve. EOT companies can make employees beneficial or actual owners in a few ways:

  • Pair an ESOP with the EOT: If the purpose of the EOT is to keep the company from being sold rather than to reduce the costs of setting up the plan, an ESOP could own up to 49%.
  • Allow employees to purchase shares: You could allow employees to buy shares at full price or at a discount. Some companies allow employees to designate a portion of their bonus or profit share for this purpose. To avoid costly regulation and disclosure, work with your attorney to structure the plan so as to avoid securities registration issues. There are a number of ways to do this.
  • Give employees restricted shares or stock options: Restricted stock is a grant of a number of shares to an employee subject to a restriction, usually vesting over a few to several years, but profitability or other metrics can be used. The employee can either make an 83(b) election at grant and pay tax on the value of the shares at the time, or pay taxes when the restrictions lapse (even if the shares cannot be sold). If the 83(b) election is made, the employee pays no tax until the shares are sold and then pays capital gains taxes on the increase in value between the grant date and the sale date. Absent an 83(b) election, the employee pays ordinary income tax when the restrictions lapse on the full value.
  • Stock options: The company can grant either qualified or nonqualified stock options. Qualified stock options (incentive stock options or ISOs) allow the employee to pay capital gains taxes on the difference between the grant price and sale price, provided the shares are held at least one year after exercise and two years after grant. Taxes are only due when the shares are sold. Nonqualified options require the employee to pay ordinary income taxon exercise based on the difference between the grant price and the price at exercise, whether the shares are sold or not.
  • Synthetic equity: Companies can grant the dollar value of a certain number of shares (phantom stock) or the increase in value (stock appreciation rights). The awards are taxable as ordinary when any restrictions (usually a vesting period) lapse.

In any of these arrangements, companies must have a way to pay the employees the value of the shares. With individual equity awards, employees may have a tax obligation when an award is exercised or vests. If they cannot sell enough shares to at least cover that cost, the award will seem more like a punishment.

Companies also need to set up rules for who gets what and when. Should the stock only be redeemable at termination, or should it pay out periodically (the latter may avoid the plan being deemed a de facto retirement plan subject to ERISA)? Should awards be based on merit, relative pay, tenure, or some combination? How will shares be valued?

Making employees actual owners can help keep the company’s focus on the long term while providing a source of wealth beyond dividends, goals worth considering an EOT to achieve.