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 giving stock as a bonus, by enabling employees to purchase it directly, or via gain sharing. There are today almost 7,000 ESOPs in America, where more than 14 million people participate.
This form of stock ownership plan can serve a number of purposes. They can be utilised as a means to motivate employees, to create a market for the stocks of former owners, or to take advantage of government tax incentives for borrowing money to buy 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 shares issued by the firm. The fund can also borrow money to buy shares of stock, together with the firm donating funds so the fund can pay back the loan.
Corporate contributions are usually tax-deductible, although current 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 greater, 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 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 be 100% vested within 3-6 decades.
Upon leaving the company, an employee must receive fair market value for their shares. For public companies, workers should receive voting rights on all issues. Private companies may restrict voting rights to such major issues as closing or relocating. Private companies also have to 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 cash. 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 receive a deduction by contributing discretionary 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 purchase shares is tax-deductible. Thus, all ESOP financing is in pretax dollars. In C corps, when the ESOP purchases more than 1/3 of the stocks in the company, the company can reinvest the gains 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 aren’t taxed. Employee gains from the fund may be taxed, though at potentially beneficial rates.
For all the advantages, however, there are a few drawbacks to the ESOP. ESOPs cannot be legally utilized 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 companies when their employees 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 good at fostering employee performance if employees have a say in decisions affecting their work. All of these are factors to consider when deciding if an ESOP is ideal for your firm.