An ESOP, or Employee Stock Ownership Plan, is a method for businesses to provide their employees shares of ownership. It can be achieved in many different ways: by giving employees stock options, by providing stock as a bonus, by enabling employees to purchase it directly, or through profit sharing. There are now almost 7,000 ESOPs in the usa, where more than 14 million individuals participate.
This kind of stock ownership plan can serve a variety of purposes. They can be utilised 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 business 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, with the company donating funds so the fund can pay back the loan.
Corporate contributions are usually tax-deductible, although recent rules restrict 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 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 workers take part 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 called”vesting.” The ESOP rules require all employees to become 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, workers must receive voting rights on all issues. Private companies may restrict voting rights to such major problems 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 offer firms. Contributions of inventory are tax-deductible, as are contributions 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 procedure. Or they can receive a deduction by contributing discretionary cash to the ESOP annually, 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 funding is in pretax dollars. In C corps, when the ESOP buys more than 1/3 of those stocks in the business, 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 aren’t taxed. Employee gains in the fund may be taxed, though at possibly favorable prices.
For all the benefits, however, there are a few drawbacks to the ESOP. ESOPs can’t be legally utilized in professional partnerships or corporations. In S corps, they don’t qualify for rollovers and have lower limits on donations. The share repurchasing mandated for private companies 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 good at fostering employee performance if workers have a say in decisions affecting their work. These are all considerations to consider when deciding if an ESOP is ideal for your firm.