Editor’s note: The companion article, “What to Know When Your Client Is Considering Employee Ownership” explores how CPAs can advise clients interested in changing their company’s ownership model.

Employee stock ownership plans (ESOPs) have gained popularity among accounting firms in response to some of the profession’s biggest trends — the influx of private equity (PE), the struggle to recruit and retain staff, and the need to fund partner retirements.

An ESOP is a form of beneficial employee ownership that has historically had a strong presence in labor-reliant trades like construction and trucking. But interest has grown in professional services like law, architecture, engineering, and accounting.

BDO USA made news in 2023 by becoming the largest accounting firm to operate under an ESOP. More than 10,000 employees are participating in BDO’s ESOP and becoming beneficial owners of the firm, according to CEO Wayne Berson, CPA.

“It was critical for us that we retain control of our own destiny, that we continue to lead our firm and steward a thriving future for all,” Berson said. “The ESOP was a clear choice to sustain a strong, caring, resilient business where every employee benefits.”

Jericho, N.Y.-based Grassi is another firm that established an ESOP in 2023. (See the sidebar, “What Is an ESOP?”)

ESOP’s TAX BENEFITS

An ESOP transition includes robust tax benefits that regulators have expanded over the years because lawmakers and think tanks across congressional party lines have supported ESOPs, said Brandon Stumpf, CPA/ABV, a senior associate with Business Transition Advisors, which specializes in ESOPs.

Under Sec. 1042, selling partners or owners may defer capital gains taxes, said Dan O’Hare, CPA, principal for Glenn Burdette, an accounting firm that transitioned to an ESOP in 2000.

“If it’s structured properly, you can write off the entire purchase price through depreciation, amortization, etc. If there’s debt involved, you’re able to deduct not only the interest on that debt but also on the principal on that debt,” O’Hare said in the “The Power of ESOPs in Reshaping Your Firm’s Future” episode of the Transforming: Tales of Business Evolution podcast produced by the AICPA’s firm services team, aka the Private Companies Practice Section (PCPS).

The firm itself may take tax deductions equal to the transaction’s value. For example, after a $100 million transaction, a firm would “receive $100 million of noncash tax deductions that you can take over time to offset future taxable income at the firmwide level,” said Michael Bannon, vice president with CSG Partners, a New York-based investment bank that has aided nearly 400 companies in making the ESOP transition. Bannon was interviewed in the “ESOP Insights: Unlocking the Future of Firm Ownership” episode of the PCPS podcast.

Also, 100% ESOP-owned firms operating as S corporations can reap an exemption in perpetuity from federal and most state income taxes.

“Those are benefits for the selling partners today, but also future partners and employees,” Bannon said.

Firm employees benefit over time from annual allocations of tax-deferred stock in the company.

ADDITIONAL BENEFITS

An ESOP’s benefits go beyond taxes.

The possibility to gain a stake in the company is an incentive to attract and retain employees. Glenn Burdette features the ESOP as a powerful perk for prospective new hires, O’Hare said. “It does differentiate our firm from other firms, and we talk a lot about it when we’re on campus recruiting. I think it’s very appealing to a lot of the young folks.”

BDO’s Berson agrees. Accounting “doesn’t have a great track record for keeping people and attracting people into the profession,” he said. “The more we looked into [an ESOP], the clearer it became that this new or younger generation wanted something more tangible.”

One study from the National Center for Employee Ownership found significantly improved retention at companies with ESOPs — a median of 5.1 years of tenure, compared with 3.5 years in other companies. In BDO’s case, turnover improved from 18% to 14% immediately after implementing the ESOP, Berson said.

Proponents also say the concept of employee ownership tends to better align individuals’ incentives with the firm’s.

“After the transaction, you still have your compensation model, of course, but it’s augmented by the fact that all partners, all staff, also have a singular vision,” Bannon said. “Instead of battling over budget and dollars, you’re thinking about how, as a firm, do we optimize our return on investment for those dollars? … It ends up being a little bit of a mind shift for the partnership as well to look more toward long-term growth and to have everyone row together toward that.”

ESOPs also can help solve succession challenges.

“It’s a liquidity strategy for those partners that are selling today. It’s also a succession plan for the future, rising partners, because they as participants in that plan will continue to allocate and build up stock over their careers within the firm,” Bannon said.

For a firm with partners approaching retirement, an ESOP may provide an alternative to a sale. “It’s a good exercise to at least evaluate what an ESOP may or may not look like for your firm [and then] decide whether it’s a good fit,” Bannon said.

Glenn Burdette first adopted its ESOP because a sizable portion of shareholders were planning to retire and the firm had a substantial unfunded retirement plan liability. O’Hare discovered the liability soon after becoming a shareholder in the early 1990s and decided a change had to happen.

“There’s no way we can sustain this unfunded liability. We have to do something about it,” he recalled thinking. “So, the next time we met, I shared with [the other shareholders] that I was going to be the last [new] shareholder that didn’t know anything about the unfunded liability.”

While some of Glenn Burdette’s then-shareholders were only lukewarm on the concept, the ESOP transition soon proved to be a crucial incentive for rising leaders to stay with the firm, O’Hare said.

“The further you got down the line [of succession in the firm], the more enthusiastic people became about it because it looked like a way to save the firm and keep it from just ending up breaking apart,” he said.

CONSIDERATIONS FOR FIRMS EXPLORING ESOPs

ESOP transactions are exceptionally complex, both in the conversion and in the ongoing administration. For the initial setup, firms should engage with high-quality valuation specialists, attorneys, and financial advisers. O’Hare recommends that firms considering an ESOP begin with a consultation with ESOP experts knowledgeable about the accounting profession.

“If you’re going to use one of the larger [advisory] firms, they would need to demonstrate that they have some understanding of the unique structure of a CPA firm and what that means in terms of formation and having that alternative ownership structure,” O’Hare said.

Bannon said that the analysis preceding an ESOP transaction must include the company’s financials, objectives, and the demographics of its partners and employees. This analysis will determine the structure, sale price, and debt levels necessary for the transaction. O’Hare also recommended obtaining an initial valuation of the firm as part of a feasibility study.

“You can decide whether or not you want to hit the green light and go on that transaction or decide to put it on the shelf for a little bit, revisit it in a couple of years, or decide it’s just not the right fit for your firm,” Bannon said.

Taking on the change requires not just financial resources but also buy-in from the partners and all the people who will be beneficial owners of the firm.

“It’s a true benefit the employees will receive, but unless you communicate it effectively internally, you’re not going to be able to maximize or optimize the benefits of that, whether it’s in retention or recruiting,” Bannon said. “Those firms that get the most out of that productivity and retention are certainly the ones that communicate to the employees what it means to be an employee-owner in a firm.”

Not every firm is prepared to make the ESOP transition. The partners may prefer to seek a higher sale price and a simpler cashout through other approaches, such as a PE or an upstream merger.

“One of the big red flags or obstacles to forming a successful ESOP is a selling shareholder who is trying to get the highest price possible. It just doesn’t work for the seller or the ESOP going forward,” said Mark Flinchum, CPA, a partner in Katz, Sapper & Miller’s Business Advisory Group and co-chair of the firm’s ESOP services group. “There are buyers in the market that can pay more than the ESOP.”

The model also may be unnecessary for young firms that don’t have significant succession questions, Bannon said.

Moreover, the firm must have the revenue to sustain the debt and administrative costs involved in an ESOP. Bannon suggested that a firm should have about $3 million in EBITDA, while O’Hare said that Glenn Burdette had about $5 million in revenues at the time of its transition.

“The biggest complaint I hear from other CPAs is that it involves taking on too much debt,” Stumpf said. “It’s the long game. You get this tax-free company that explodes in value.”

When firms are ready to make the transition, they often find that lenders are willing and interested, thanks to the way ESOP tax benefits can result in favorable financial ratios post-transaction. That’s helped to keep the rate of ESOP deals going strong despite higher interest rates, Bannon said.

“You’re able to get that funding even as interest rates are slightly elevated, as they have been the last couple of years,” he said.

TRANSITIONING TO AND OPERATING AN ESOP

ESOP transitions are not all-or-nothing decisions. Partners may choose to sell only part of the firm initially, typically 30% or more, and sell additional tranches of equity to an ESOP at later dates, Bannon said. In the case of Glenn Burdette, the shareholders initially sold 85% of their stock to the ESOP and the remainder a decade later.

This flexibility is another attractive benefit for selling partners, Bannon said. If only a portion of partners want to sell to the ESOP, they may do so, with other partners following later if they choose.

“You can absolutely do that in waves over time,” he said.

Creation and operation of an ESOP requires several changes:

• Forming an employee stock ownership trust, led by an independent trustee.
• Selecting a third-party administrator for the plan.
• Conducting annual valuations after the sale.

An ESOP transaction must be consummated at fair market value (FMV).

“From a valuation perspective, an ESOP is a regulated transaction, and so ERISA [the Employee Retirement Income Security Act of 1974] states that the ESOP can only pay what’s deemed fair market value,” Bannon said. In contrast, buyers such as PE firms may pay a premium over FMV.

The FMV requirement for ESOPs means firm owners may sacrifice some of the immediate payout that they could receive in other sale types, though that may be balanced by tax benefits and a desire to sell to employees.

In an ESOP, the debt can come from outside lenders or in the form of sellers’ notes — essentially an “IOU” paid by the firm over time. Especially strategic buyers such as PE firms will tend to contribute more equity to complete the deal.

An ESOP transaction typically requires the establishment of an alternative practice structure. Because the ESOP ownership usually is structured as a trust, the firm is split into an attest entity owned by CPAs to handle audit and attest work and a nonattest entity that owns the trust. (BDO, however, did not split its practice structure.)

Upon sale, ownership of the firm is placed in a trust overseen by the independent trustee. The trustee’s responsibilities include ensuring fair market valuation of the business and negotiating the deal at arm’s length.

The trustee also plays an ongoing role, including ensuring annual valuations are carried out (which is crucial for determining employee share values). And the trustee represents employee interests, such as by attending leadership meetings and reviewing financial information.

Ongoing administration requires that the firm retain outside experts, including an independent adviser who can carry out annual valuations and an external legal counsel. A third-party administrator manages the plan itself — determining how many shares are owed to each individual, accounting for vesting schedules, and calculating the value of stock.

Typically, employees accumulate shares throughout their tenures at the company, but access to these shares is initially limited through a vesting schedule. For example, employees may gain rights to their accumulated shares once they’ve been with the company for three years, a design known as cliff vesting. Alternatively, employees may earn their allocated shares in 20% yearly increments over a five-year period, a design known as graded vesting.

As employees leave or retire, their shares are repurchased by the firm at their current FMV. The firm can then opt to contribute that stock to the trust for reallocation or retire those shares to treasury. “The purpose of that is to make sure that there’s a sustainable benefit for future employees, so there’s stock still available for them as they join the firm,” Bannon said.

Over time, the plan can add up to substantial retirement benefits for employees. But maximizing the potential of the plan — especially for improved employee retention and engagement — means ensuring that employees understand the plan. An ESOP is in some ways similar to a 401(k), generating wealth for the employee in a retirement plan with significant penalties for early withdrawal. But instead of investing in a diversified portfolio, the ESOP holds shares of the company itself, tying employees’ retirement plan value to the company’s performance. The ESOP combines the benefits of a retirement plan with the incentives and risks of employee ownership.

Ultimately, ESOP implementation may take a year or more, and paying off the debt for the transaction takes longer. Stumpf said many of his clients take a five-year bank note but often are able to pay it back in as few as three years.

“A lot of … these companies are able to retire the debt very quickly,” Stumpf said of the two dozen ESOP transactions he’s worked on. “It really invigorates the employees, it makes them think like owners, once they see that account balance start climbing.”

What is an ESOP?

Technically, an employee stock ownership plan (ESOP) is a Sec. 401(a) qualified defined contribution plan. It is governed by the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA) of 1974. ERISA is administered in part by the IRS and in part by the U.S. Department of Labor (DOL).

An ESOP allows employees to own stock in the company for which they work. It is created as a tax-advantaged buyout that transfers stock ownership from a business’s shareholders to a trust representing the interests of a broad group of employees. ESOPs can be leveraged or non-leveraged.

Over their working tenure, employees gain shares in the plan that they can cash out or roll over when they leave or retire. The resulting long-term employee retirement benefit is powered by the firm’s performance of the firm itself.

The ESOP model generally does not grant employees decision-making power within the firm but rewards them based on its performance. Employees may vote their shares in the event of a proposed sale or merger of the firm.

An ESOP often includes a synthetic equity pool for partners, granting additional financial benefits modeled on the rewards they previously would have received from traditional partnership shares.

For many firms, an ESOP conversion will result in a long-lasting new structure. But it may be necessary to unwind the ESOP, converting the firm once more to a different structure.

Two possibilities are:

• A leveraged buyout by management, or
• A sale to a third-party.

In both cases, money from the sale is used to pay outstanding debt, and then the proceeds are generally distributed to employees.

About the author

Andrew Kenney is a freelance writer based in Colorado. To comment on this article or to suggest an idea for another article, contact Jeff Drew at Jeff.Drew@aicpa-cima.com.

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Articles

“Valuations Performed for Employee Stock Ownership Plans (ESOPs) and FAQs,” AICPA & CIMA, Oct. 1, 2023

“What Every Valuation Analyst Should Know About Employee Stock Ownership Plans (ESOPs),” AICPA & CIMA, Oct. 1, 2023

“ESOP Exploration: Can the ‘New’ Ownership Model Age Well?” JofA, Sept. 5, 2023

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