Today’s economy presents numerous challenges to community bank profitability—compressed net interest margins, increased regulation, and management teams fatigued by the crisis. In response to these obstacles, many boards of directors are exploring new ways to reduce expenses, retain qualified management teams, and offer opportunities for liquidity to current shareholders short of a sale or merger of the institution.

For many family-owned banks, their deep roots in the community and a desire to see their banks thrive under continued family ownership into future generations can cause these challenges to be felt even more acutely. In particular, recruiting and retaining the “next generation” of management can be difficult. Cash compensation is often not competitive with the compensatory packages offered by publicly-traded institutions, and equity awards for management officials are unattractive given the limited liquidity of the underlying stock. All the while, these institutions should ensure that their owners have reasonable assurances of liquidity as needs arise or as investment preferences change. In combination, these challenges can often overwhelm a family-owned bank’s desire to remain independent.

Depending on the condition of the institution, implementing an employee stock ownership plan, or ESOP, may help a board address many of these challenges. While the ESOP is first a means of extending stock ownership to the institution’s employees, an ESOP can have other applications for family-owned banks.

Recruitment and Retention

An obvious benefit of an ESOP is to provide management and employees the ability to participate in an increase in the value of the bank, aligning their interests with those of shareholders. An equity interest provides economic incentives to join or stay with the bank and the ownership interest provided by ESOPs to employees has been shown to improve workforce productivity and morale.

Source of Liquidity for Shareholders

Without significant trading activity in their stock, shareholders of a closely-held institution may seek a liquidity event, which can include the sale of their shares to a third party or a merger with another bank. For these institutions, using the ESOP as part of a stock repurchase plan or to buy out selected shareholders can provide a buyer for large blocks of stock at a reasonable price.

For family-owned institutions, the tax benefits associated with a sale of a family’s interest in the institution to management via an ESOP are considerable. Most individual sellers of stock to an ESOP (and some trusts) qualify for a tax-free rollover of the proceeds of that sale into domestic stocks and bonds of U.S. corporations which meet certain limits on passive income. Under certain circumstances, this tax-free rollover opportunity avoids all federal income and capital gain taxes on the sale of shares to an ESOP.

In order to fund large purchases, the ESOP can take on a limited amount of leverage in order to acquire more shares in a particular year than can otherwise be allocated to plan participants. Before taking on this leverage, the bank should carefully consider how much leverage it can actually handle relative to the contributions that are expected to be made to the ESOP.

Special Benefits for S Corporations

ESOPs can also reduce shareholder numbers to facilitate a company’s conversion to an S corporation, which can help significant shareholders avoid the double taxation of dividends that apply to C corporations. Under the Internal Revenue Code, an ESOP counts as only a single shareholder for purposes of S corporation limitations, no matter how many employees have shares allocated to their accounts in the ESOP. Upon a plan participant’s separation from service from the institution, the participant may be entitled to only the cash value of the shares, rather than the shares themselves.

ESOPs also benefit from the S corporation status given their exemption from federal and most state income taxes. Since ESOPs are tax-exempt entities, they do not pay income taxes on their share of the institutions’ income like other shareholders do. When S corporations make distributions to their shareholders, ESOPs can retain that distribution, giving a better return to the ESOP participants. Additionally the cash reserves held in the ESOP from these distributions can be used to pay down ESOP debt incurred to buy shares for the ESOP, fund additional stock purchases by the ESOP, or to fund employee withdrawals from the ESOP.

For a variety of reasons, ESOPs can help family-owned financial institutions better manage the challenges of today’s market by providing a more liquid market for the institution’s shares and an exit strategy for some significant investors short of a sale or merger. ESOPs can also improve employee and senior management engagement and retention at a relatively low cost, which can improve the institution’s bottom line. With careful implementation and board oversight of compliance efforts, ESOPs can be a powerful tool for many community banks.

This article was originally published on BankDirector.com.