There are many different types of benefits that help drive employee engagement and retention. One type of benefit plan that does this is known as an employee stock ownership plan (ESOP). In this article, we will take a look at what an ESOP is and how it works.
What is an ESOP?
An employee stock ownership plan (ESOP) is a type of employee benefit plan that gives the employees of the business ownership interest in the company through shares of stock. Employees can own all or part of the stock in a company. Often times, these types of plans are used as a strategy to help align the interests of the employees and the shareholders.
How does it work?
Here is how an employee stock ownership plan works.
- The company first sets up an ESOP trust.
- Into that trust, the company can either contribute cash to buy shares of stock from existing owner(s) at fair market value, or if the owner does not want to sell shares, the company can issue new shares.
- If the company doesn’t have the cash to do this at the outset, the ESOP can take out a loan to buy new or existing shares while the company contributes money so that the trust can pay its’ loan.
- Employees get shares in the trust, usually distributed according to relative pay. As they work longer for the company, they get an increased right to the shares, also known as vesting. Generally, all full-time employees over 21 must be able to participate in the plan.
- When an employee leaves the company, they receive their stock, which the company must buy back from them at fair market value (unless there’s a public market for the shares). So, the employee receives the value of his or her shares from the trust, usually in the form of cash.
What are the benefits of an ESOP?
Setting up an ESOP has multiple benefits.
- Companies use an ESOP to motivate employees to perform to their highest potential. Since employees are part owners of the business, the better the business does financially, the better the employee does.
- These plans encourage participants to do what’s best for shareholders, since the participants themselves are shareholders.
- Having a stake in the company can make employees feel more appreciated and increase engagement and retention.
- Companies typically tie distributions from the plan to vesting, which gives employees rights to employer-provided assets over time.
- There are also tax benefits associated with ESOPs.
- Cash contributions and contributions of stock are tax-deductible.
- Contributions that are used to repay the loans the ESOP takes out to purchase company shares are also tax-deductible.
- An S-Corporation allows owners to avoid double taxation on corporate earnings and their percentage of ownership held by the ESOP.
- A C Corporation has an additional tax benefit of allowing sellers who own at least 30% of the stock to defer taxation on the gain.
- Dividends that are used to repay an ESOP loan, passed through to employees, or reinvested by the employees in company stock are also tax-deductible.
- Employees do not pay tax at the time of contributions into the ESOP. They are taxed at the time of distributions, and the rates they are taxed on is favorable to the participant.
How to businesses start a plan?
Businesses that have a long history of profitability with low debt to equity ratio and a strong and trusted management team are good candidates for this type of plan. Interested companies should:
- Discuss if all owners of a company are willing to either sell shares or dilute their shares.
- Conduct a feasibility study. A feasibility study looks at how much extra cash the company has to give to the ESOP and whether this amount of cash is adequate for the purpose of the ESOP.
- Conduct a valuation of the business itself – if the value is too low, the seller may not want to sell. If too high, the company may not be able to afford to buy these shares.
- Next, consult an attorney to help you draft and submit your Plan to the IRS.
- Obtain funding for your ESOP.
- Establish a process to operate your plan.