A Smart Way for Business Owners and Nonprofits to Curb Financial Inequality

In an era when concerns about economic fairness are driving much of our political conversation, there is a bipartisan approach, too little used, that deserves more attention and support in the nonprofit world: employee stock-ownership plans.

Blessed by a series of congressionally provided tax benefits, these plans have been shown to help the owners, companies, and employees who participate.

Charities and foundations dedicated to curbing inequality would be especially wise to endorse this approach. But all nonprofits can benefit from such plans because they create opportunities for owners of closely held companies to use the gains from appreciated stock to make substantially larger contributions to their favorite causes.

Consider, for instance, Bill Parks, founder of Northwest River Supplies, a provider of rafts, fishing gear, and other outdoor equipment. When he reached 80, he sought a way to transfer his ownership stake. He wanted to find a way to make the sale work for him, for the employees who were so critical to the success of the company, and for the charitable interests he deeply values.

Ideally, he thought, the employees could buy the company from him. But he realized few had enough money to do that, and they certainly had little ability to take on the financial risk of owning a company. Unwilling to give up on the idea, Parks found that an employee stock-ownership plan, or ESOP, could achieve the goals he had in mind.

Another successful businessman, Bill Roark, started Torch Technologies in Huntsville, Ala., in 2002 with his partner, Don Holder. Roark is still the CEO, but the company is now fully owned by its employees.

For many companies, employee ownership is an ideal mechanism for business continuity. The approach works as a kind of employee benefit plan, similar in many ways to 401(k) plans for retirement savings. The company transfers stock shares to a trust it holds for employees.

Hefty Tax Benefits

At both Northwest River Supplies and Torch, as in almost all ESOPs, the transfer has made employees the owners not through outright purchase of shares but because the company contributed future profits to an employee ownership trust.

Congress wants to encourage the use of ESOPs, so these plans offer substantial tax benefits that owners like Parks, Roark, and Holder would not derive if they sold to more traditional buyers. One key condition of an ESOP is that its stock must benefit all employees; Congress doesn’t want anybody using the approach to get tax breaks by rewarding just a few senior-level employees.

The tax benefits are even better if an owner wants to support charity. For an owner of a closely held company, the only way to avoid capital-gains taxes would be to donate the shares directly to the charity. That is feasible, but it’s complicated and full of uncertainty.

It’s a lot easier for the owner to sell the company, pay capital gains, then donate the remaining amount to a charity. With an ESOP, however, Parks, Roark, and Holder were able to donate the full amount of the proceeds of the sale and get a deduction for the entire amount. Parks bought replacement stocks on the stock market and donated those; Roark and Holder donated Torch shares directly, and the charity then sold them to the ESOP. This type of transaction allowed the men a bigger deduction, and the charities got a bigger contribution.

Multiple Gains

Parks was optimistic that operating as an ESOP would lead his company to follow the well-documented pattern of other ESOPs in achieving higher productivity while providing an important source of wealth and job stability to employees. Since its reorganization as an ESOP, Northwest River Supplies has been growing at a record pace, with its stock price up more that 120 percent in just two years and its sales 25 percent higher.

At Torch, the growth has been even faster. The company had 50 employees in 2005 and now has 700. On top of that, for three years in a row Fortune magazine has named Torch one of the best places to work in consulting and professional services.

The Torch story is part of collaborative efforts between Huntsville companies that are employee-owned and the Community Foundation of Greater Huntsville.

Huntsville has a large number of employee-owned companies. Many owners who sold their companies to ESOPs (as well as employees who have received the stocks) have donated shares directly to the foundation, which then sells them back to the ESOPs. Through the approach, the foundation has raised $5.7 million in just a few years.

Wave of Transfers at Hand

These stories are by no means unusual. More than 6,000 closely held companies in the United States operate as ESOPs, and many of their owners have contributed to charity using this mechanism. The approach is especially relevant now because the second-largest source of wealth in the country, after homeownership, is ownership of privately held companies (ones not traded on stock exchanges).

In the next 10 years, as baby boomers retire in large numbers, trillions of dollars will change hands through company transfers of ownership. Many of the owners of these businesses are very charitable.

Given the tax advantages — the ability to fund an ESOP with pretax money and for sellers to get a capital-gains deferral on the proceeds — ESOPs can make it a lot easier and more financially rewarding for business owners to contribute the appreciated value of their company to charity. To make that happen, development offices need to make small-business owners aware of the option.

Fortunately, free resources are available to help the process. You don’t need to be an expert in ESOPs, you just need to know where to direct people. Few business owners whose companies are good candidates for the approach know how an ESOP works or how it can benefit them. Once they know the basics, many more business owners are likely to pursue this route.

Foundations and other charitable institutions also should look to support employee ownership because the approach can help advance the mission of improving the lives of Americans. A new study called “Employee Ownership and Economic Well-Being,” — by the organization I head, the National Center for Employee Ownership — found, based on data from the Bureau of Labor Statistics National Labor Survey, that being in an employee-ownership plan can greatly improve financial well-being, including for those most at risk.

The study looked at people 28 to 34 years old. By comparing people in employee-ownership plans to those who were not, the study found, among other things, that people of color in employee-ownership plans had:

• 79 percent higher median household net wealth.
• 30 percent higher median wages.
• 36 percent greater job tenure.

It also found that workers with under $30,000 in annual income had:

• 17 percent higher median household net wealth.
• 22 percent higher median wages.
• 11 percent greater job tenure.

Improved Financial Well-Being

Previous research by the National Center for Employee Ownership and others has found that employees in these plans accumulate 2.2 times the retirement assets of employees not in ESOPs. Because of how the rules work, the positive effects are strongest for lower-income workers. Compared with employees in companies with other ownership arrangements, employees of ESOPs were also much less likely to have been laid off.

As baby boomers who own closely held companies retire and look for liquidity, hundreds of billions of dollars in assets will be turning over. That presents an enormous opportunity for charities.

While charities can use conventional approaches to seek the support of these owners, encouraging them to sell to a stock-ownership plan is an incredibly powerful option. As the examples in Huntsville show, the approach allows a seller to preserve the company’s legacy while building one in the community as well — all with substantial tax benefits.

Charities get higher contributions; sellers get higher deductions. The employee-owned companies will also help cities and towns thrive by keeping business ownership local and ensuring a strong work force.

Corey Rosen is founder of the National Center for Employee Ownership, which offers resources to help nonprofits, businesses, and others better understand employee-ownership plans.