An ESOP, or Employee Stock Ownership Plan, is a way for businesses to give their employees shares of ownership. It can be achieved 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 the usa, in which 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 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 provider’s investment in its employees, not a purchase by employees.
Rules and Structure
To establish an ESOP, the company 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 buy shares of stock, together with the company contributing capital so the fund can repay 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 which are entirely owned by an ESOP, which do not pay any taxes.
While typically all fulltime 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 business, an employee must receive fair market value for his or her shares. For public companies, workers must 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 lots of 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 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 every year, either to purchase 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 those stocks in the company, the business can reinvest the gains 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 from the fund may be taxed, though at possibly favorable prices.
Limitations
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 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 installation is only effective at boosting employee performance if employees have a say in decisions affecting their work. These are all factors to consider when deciding if an ESOP is right for your firm.