Why ESOPs are a Good Idea for Private Companies Going Public

It’s Complicated … but the Benefits Apply to Management, Employees and VC/PE Sponsors

By John Vitucci, Partner and ESOP Practice Leader

Private businesses with Venture Capital (VC) or Private Equity (PE) sponsors that expect to go public with an initial public offering (IPO) should consider establishing an Employee Stock Ownership Plan (ESOP) — then think about Roth conversions. While it may seem a bit complicated, there are sound reasons why this is a good idea. We explain below in the following sequence:

• Align on the plan types: ESOP, 401(k), KSOP, Roth.
• Outline the advantages of ESOPs and Roth Conversions (and a possible disadvantage).
• Review the next steps to guide you to the correct implementation for your corporation.

What’s an ESOP, KSOP, Roth?

A company can establish a Trust which purchases shares of its stock or contribute cash to an ESOP to buy available shares.

An ESOP is a qualified retirement benefit plan that allows employees to own some (partial) or all (100%) of their company through stock allocation at no cost to them. Allocation to employees may be based on their compensation, years of service or other allocation methods. The shares are then put in individual employee accounts that vest over time (typically three years to vest). In general, participants pay taxes when they receive a distribution from their ESOP account (usually at retirement) unless they had made a Roth  election. Upon retirement or another distribution event, funds can be rolled over to an IRA and possibly another retirement account. An ESOP can stand alone or be part of a 401(k) plan.

A 401(k) allows employees to contribute a portion of their wages to an individual investment account.

KSOP: Hundreds of public and private companies have combined ESOP and 401(k) features. These are sometimes referred to as KSOPs. 

Roth IRA: Unlike traditional individual retirement accounts (IRAs), Roths are funded with after-tax dollars and allow the account holder to make tax-free withdrawals in retirement.

Roth In-Plan Conversion: ESOPs and KSOPs can separately or be combined to allow for what is called a designated Roth contribution and In-Plan Roth conversion regarding any investment in the plan, including privately held securities.  To execute a Roth, the account must be fully vested.

Advantages of the ESOP: Share in Appreciation; Tax-Free Growth for Retained Earnings

As the value of a company increases or decreases, so does the value of its shares in the ESOP retirement account. Stock can be allocated immediately or over time.

For Private Companies: Because private company ESOPs are not publicly traded, there is no market value for the shares. An independent appraiser determines what shares should be worth, with appraisals typically conducted annually so employee owners can track the value of their shares. If a company has an IPO, then the independent valuation is generally not required and the stock price is determined by the public markets.

For S Corporations: There are unique benefits of establishing an ESOP for S Corporations. The Internal Revenue Code excludes the earnings of a Subchapter S Corporation allocable to an ESOP from taxation. These provisions were added by Congress to incentivize employee ownership. Because an S corporation can have retained earnings, the ability to have such retained earnings grow tax-free represents a powerful vehicle.

Advantages of the Roth: Potential for Tax Free Distribution After Explosive Growth

A participant in an ESOP or KSOP may choose to convert a vested account balance to a Roth account, as a Roth contribution or conversion. This is not a distribution (because no money leaves the plan), but the participant will be taxed on the amount of the Roth contribution election or conversion.  Because it is not considered a regular distribution, automatic withholding and the 10% early distribution penalty do not apply.

An advantage of a Roth account is that a participant can pay tax on an amount now on an investment that may have a low value today but later, when they receive a qualified distribution from the account, it is tax free.  Many VC or PE investments that go public through an IPO can have explosive growth especially with a business that develops a new leading-edge product or technology.

Many VC or PE investments are set up as corporations and many may not be current taxpayers for various reasons (credits or depreciation). However, the ability to execute a Roth conversion can offer significant tax benefits to employees and the management team. The VC or PE firm can also take advantage of the ESOP structure.

Possible Disadvantage: Little or No Appreciation

A negative of executing a Roth is that a participant will potentially be paying taxes today on an investment that may not appreciate, can potentially go out of business or go bankrupt.

Next Steps to Help You Solve the Complexities of the ESOP/Roth Process

As a first step, please review our additional resources to learn more:

• PKF O’Connor Davies Employee Stock Ownership Plan Accounting and Consulting
• Optimization of ESOP Value and Rewards Programs by John N. Vitucci, CPA, Partner

We also invite you to engage us directly. ESOPs with Roth features can be complex to implement, have unique design features and require experienced professionals who have implemented many ESOPs with these design features. We’re here to help guide you through those complexities. 

Contact Us

If you have any questions regarding ESOPs, Roth Conversions or how to implement for your public or private company, please contact your PKF O’Connor Davies relationship manager or feel free to reach out to me directly:

John Vitucci
Partner and ESOP Practice Leader
jvitucci@PKFOD.com | 917.841.8718