An ESOP, or Employee Stock Ownership Plan, is a method for businesses 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 via profit sharing. There are today almost 7,000 ESOPs in the usa, 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 way to motivate employees, to make 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 companies. ESOPs typically constitute the provider’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 either cash to buy shares of stock or new stocks issued by the firm. The fund can also borrow money to purchase 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 limit deductions to 30 percent of earnings before interest, taxes, depreciation, and amortization (EBIDTA). For instances where the loan is large relative to EBIDTA, in other words, taxable income might be higher, except for S-corps that are completely owned by an ESOP, which don’t pay any taxes.
While typically all full-time adult employees participate in the plan, shares are usually allocated to employee accounts based on relative pay. Typically, more senior level employees have greater access to the shares 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 must receive fair market value for his or her shares. For public companies, employees must receive voting rights on all issues. Private companies may restrict voting rights to such major issues as closing or relocating. Private companies must also have a yearly outside valuation to ascertain the value of their shares.
ESOP Tax Benefits
There are many tax benefits that ESOPs provide firms. Contributions of inventory are tax-deductible, as are gifts of money. 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 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 stocks in the business, 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 possibly favorable rates.
For all the advantages, however, there are some drawbacks to the ESOP. ESOPs cannot 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 effective at boosting employee performance if employees have a say in decisions affecting their work. These are all considerations to take when determining if an ESOP is ideal for your firm.