An ESOP, or Employee Stock Ownership Plan, is a way for companies to give their employees shares of ownership. It can be achieved in a variety of ways: by giving employees stock options, by providing stock as a bonus, by enabling employees to purchase it directly, or through profit sharing. There are now almost 7,000 ESOPs in America, where more than 14 million individuals participate.
This kind of stock ownership plan can serve a variety of purposes. They can be used as a means to motivate workers, to create a market for the shares of former owners, or to take advantage of government tax incentives for borrowing money to purchase new assets. Only relatively rarely are they used to shore up troubled businesses. ESOPs typically constitute the provider’s investment in its employees, not a purchase by employees.
Rules and Structure
To establish an ESOP, the company must establish a trust fund into which may be deposited either cash to buy shares of stock or new stocks issued by the company. The fund can also borrow money to purchase shares of stock, with the company contributing capital so the fund can pay back the loan.
Corporate contributions are typically tax-deductible, although recent rules limit deductions to 30% of earnings before interest, taxes, depreciation, and amortization (EBIDTA). For cases where the loan is large relative to EBIDTA, in other words, taxable income may be higher, except for S-corps that are entirely owned by an ESOP, which do not pay any taxes.
While typically all full-time adult workers take part in the plan, shares are usually allocated to employee accounts based on relative pay. Typically, more senior level employees have greater access to the stocks in their account. This is known as”vesting.” The ESOP rules require all workers to be 100% vested within 3-6 decades.
Upon leaving the company, an employee should receive fair market value for his or her shares. For public companies, workers must receive voting rights on all issues. Private companies may restrict voting rights to such major problems as relocating or closing. Private companies must also have a yearly outside valuation to ascertain the value of their stocks.
ESOP Tax Benefits
There are many tax benefits that ESOPs offer firms. Contributions of stock are tax-deductible, as are contributions of cash. Companies can issue new shares of stock or treasury to the ESOP to create a current cash flow advantage, albeit diluting owners in the process. Or they can be given a deduction by contributing discretionary cash to the ESOP annually, either to purchase shares or develop a reserve.
Further, any contribution the company makes to repay a loan used by the ESOP to purchase shares is tax-deductible. Thus, all ESOP financing is in pretax dollars. In C corps, when the ESOP buys more than 1/3 of those stocks in the company, the business can reinvest the profits on the sale in other securities and defer tax.
S corps do not have to pay any income tax on the percentage owned by the ESOP. Dividends used to repay ESOP loans are tax-deductible, and employee contributions to the fund aren’t taxed. Employee gains from the fund may be taxed, though at potentially beneficial prices.
For all the advantages, however, there are some drawbacks to the ESOP. ESOPs can’t be legally used in professional partnerships or corporations. In S corps, they don’t qualify for rollovers and have lower limits on contributions. The share repurchasing mandated for private businesses when their employees leave is expensive, as is the cost of setting up an ESOP. Issuing new shares can dilute those of program participants, and the installation is only good at boosting employee performance if employees have a say in decisions affecting their work. All of these are factors to take when determining if an ESOP is ideal for your firm.