What’s an esop
An ESOP, or Employee Stock Ownership Plan, is a way for companies to provide their employees shares of ownership. It can be done in many different ways: by giving employees stock options, by giving stock as a bonus, by enabling employees to purchase it directly, or through gain sharing. There are today almost 7,000 ESOPs in America, in which more than 14 million people participate.
This form of stock ownership plan can serve a number of purposes. They can be used as a way 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 purchase shares of stock or new stocks issued by the firm. The fund may 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 cases where the loan is large relative to EBIDTA, in other words, taxable income might be greater, except for S-corps that 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 employees to become 100% vested within 3-6 years.
Upon leaving the company, an employee must 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 big issues 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 many tax benefits that ESOPs offer firms. Contributions of stock are tax-deductible, as are contributions 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 process. Or they can receive 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 funding is in pretax dollars. In C corps, when the ESOP buys more than 1/3 of the stocks in the company, the company 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 rates.
For all the benefits, however, there are a few drawbacks to the ESOP. ESOPs can’t be legally utilized in professional corporations or partnerships. In S corps, they don’t 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 plan participants, and the setup is only effective at fostering employee performance if workers have a say in decisions affecting their work. These are all considerations to take when deciding if an ESOP is ideal for your firm.