An ESOP, or Employee Stock Ownership Plan, is a method for companies to give their employees shares of ownership. It can be done in a variety of ways: by giving employees stock options, by providing stock as a bonus, by allowing employees to purchase it directly, or through gain sharing. There are today almost 7,000 ESOPs in America, where more than 14 million individuals participate.
This kind of stock ownership plan can serve a number of purposes. They can be used as a way 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 buy shares of stock or new stocks issued by the firm. The fund can also borrow money to buy shares of stock, together with the company donating funds so the fund can repay the loan.
Corporate contributions are usually tax-deductible, although current rules restrict 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 might be higher, except for S-corps which are completely owned by an ESOP, which do not pay any taxes.
While typically all full-time 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 known as”vesting.” The ESOP rules require all employees to be 100% vested within 3-6 decades.
Upon leaving the company, an employee should receive fair market value for their shares. For public companies, employees 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 shares.
ESOP Tax Benefits
There are lots of tax benefits that ESOPs provide firms. Contributions of stock are tax-deductible, as are gifts of money. Companies can issue new shares of stock or treasury to the ESOP to generate a current cash flow advantage, albeit diluting owners in the procedure. Or they can be given a deduction by contributing optional 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 the shares 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 are not taxed. Employee gains in the fund may be taxed, though at potentially beneficial prices.
For all the benefits, however, there are a few drawbacks to the ESOP. ESOPs can’t be legally used in professional partnerships or corporations. In S corps, they do not qualify for rollovers and have lower limits on donations. 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 plan participants, and the installation is only effective at boosting employee performance if workers have a say in decisions affecting their work. All of these are considerations to take when deciding if an ESOP is ideal for your firm.