What’s an ESOP

An ESOP, or Employee Stock Ownership Plan, is a way for companies to give their employees shares of ownership. It can be done in a variety of ways: by giving employees stock options, by giving stock as a bonus, by allowing employees to purchase it directly, or through profit 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 variety of purposes. They can be used as a way 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 companies. ESOPs typically constitute the company’s investment in its employees, not a purchase by employees.

Rules and Structure

To set up an ESOP, the company must establish a trust fund into which may be deposited either cash to purchase shares of stock or new shares issued by the firm. The fund can also borrow money to purchase shares of stock, with the firm contributing capital so the fund can repay the loan.

Corporate contributions are typically tax-deductible, although recent 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 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 typically allocated to employee accounts based on relative pay. Typically, more senior level employees have greater access to the shares in their account. This is called “vesting.” The ESOP rules require all employees to be 100% vested within 3-6 years.

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 determine 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 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 process. 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 buy 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 shares in the company, the company 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 potentially beneficial rates.

Limitations

For all the advantages, however, there are some drawbacks to the ESOP. ESOPs cannot be legally used 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 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 setup is only effective at boosting employee performance if employees have a say in decisions affecting their work. These are all considerations to take when deciding if an ESOP is right for your firm.