An ESOP, or Employee Stock Ownership Plan, is a method for companies to provide their employees shares of ownership. It can be achieved in a variety of ways: by giving employees stock options, by giving stock as a bonus, by allowing employees to buy it directly, or through profit sharing. There are today almost 7,000 ESOPs in America, in which more than 14 million individuals participate.
This form 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 company’s investment in its employees, not a purchase by employees.
Rules and Structure
To set up an ESOP, the business must establish a trust fund into which may be deposited cash to purchase shares of stock or new shares issued by the firm. The fund can also borrow money to purchase shares of stock, with the company donating funds so the fund can repay the loan.
Corporate contributions are typically tax-deductible, although current rules restrict deductions to 30 percent 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 which are entirely owned by an ESOP, which don’t pay any taxes.
While typically all fulltime adult employees take part in the plan, shares are typically allocated to employee accounts based on relative pay. Typically, more senior level employees have greater access to the stocks in their account. This is called”vesting.” The ESOP rules require all workers to become 100% vested within 3-6 decades.
Upon leaving the business, an employee should receive fair market value for their 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 also have to have a yearly outside valuation to determine the value of their shares.
ESOP Tax Benefits
There are many tax benefits that ESOPs provide 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 receive a deduction by contributing optional cash to the ESOP every year, either to buy shares or build up a reserve.
Further, any contribution the company makes to repay a loan used by the ESOP to buy shares is tax-deductible. Thus, all ESOP funding is in pretax dollars. In C corps, when the ESOP buys more than 1/3 of the shares in the business, the company can reinvest the profits on the sale in other securities and defer tax.
S corps don’t 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 are not taxed. Employee gains in the fund may be taxed, though at potentially beneficial rates.
For all the advantages, however, there are some drawbacks to the ESOP. ESOPs cannot be legally used in professional corporations or partnerships. In S corps, they do not qualify for rollovers and have lower limits on contributions. The share repurchasing mandated for private businesses when their workers 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 effective at fostering employee performance if workers have a say in decisions affecting their work. These are all factors to take when determining if an ESOP is right for your firm.