Could Transitioning to an ESOP Jeopardize Your Company’s Status as a Disadvantaged Business Enterprise (DBE) or Other Preferred-Status Certifications?

Could Transitioning to an ESOP Jeopardize Your Company’s Status as a Disadvantaged Business Enterprise (DBE) or Other Preferred-Status Certifications?

Amy CrouzerBy Amy Crouzer, CPA

Preferred-status certifications, such as a minority-owned or women-owned business designations, are designed to increase economic opportunities for historically disadvantaged groups. Similarly, one of the many purposes of an employee stock ownership plan (ESOP) is to increase economic opportunities for working-class Americans by giving them the opportunity to own stock in a company. Unfortunately, there can be challenges in these two programs working together.

If your company holds a preferred-status certification, here’s what you should know before you consider transitioning to an ESOP.

Preferred-status certification standards might not extend to an ESOP

Most certifying agencies have some requirements around ownership and control as it relates to preferred status and this can present challenges within the ESOP structure. The ESOP trust is a legal entity, not an individual, so it cannot meet the ownership requirement set out by most certifying agencies. This means that if an ESOP trust owns more than 49% of your company’s stock, your company may not qualify for preferred status. Some certifying agencies have noted they are able to look through the ESOP to determine eligibility; however, this can pose some additional issues.

Even if your certifying agency is able to look through the ESOP, the agency could potentially require a re-certification process every year. This might include, for example, reporting the individual personal net worth of your female ESOP participants to maintain WBE status. In addition, a change in the composition of your staff could alter the ESOP’s ownership percentage and potentially change your preferred status.

The control requirement can also pose an issue in an ESOP structure because the company’s owners are the majority of the workforce and not necessarily those that are controlling the company. The traditional tests of control used by certifying agencies may not translate well to an ESOP structure.

Certification standards are vague and inconsistent

Countless agencies and entities grant preferred-status certifications and their certification standards vary. Many are unclear on how an ESOP could impact a company’s ability to qualify for or maintain certification, and certifying agencies may require companies to transition to an ESOP before approving the new ownership structure.

Don’t lose heart! Do your research and consider your options

There have been instances of 100% ESOP-owned businesses qualifying for or maintaining preferred-status certification, so it is possible.

The National Center for Employee Ownership (NCEO) maintains a database that catalogs basic requirements for preferred-status certifications: www.nceo.org/r/preferreddatabase.

If your business has preferred status and you are considering an ESOP, here are a few steps you can take (courtesy of NCEO):

  1. Research your certification agency’s policy on ESOPs.
  2. Request advance assurance of your certification from your certifying agency.
  3. If your certifying agency’s policy on ESOPs is unfavorable, provide examples from other certifying agencies that allow ESOPs.
  4. Consider designing your ESOP to maximize your chances of meeting ownership and control requirements.
  5. Consider a phased transition or partial sale to alleviate the risk of the ESOP owning more than 49% of your company’s shares. Phasing the transition may allow you to present a stronger case to your certifying agency, too.

Make the right decision for your business

It’s important to consider the pros and cons of an ESOP before making your decision. The JAK team is here to help you evaluate your decision and guide you in weighing the tax implications of an ESOP. We can also support you, as a member of your advisory team, in setting up an ESOP.

If you have questions about how an ESOP could impact your business, contact us today.

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