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An ESOP, or Employee Stock Ownership Plan, is a way for companies to give 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 allowing employees to buy it directly, or through profit sharing. There are today 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 buy 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 establish an ESOP, the company must establish a trust fund into which may be deposited cash to buy shares of stock or new shares issued by the company. The fund may also borrow money to purchase shares of stock, with the company contributing capital so the fund can pay back 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 higher, except for S-corps which are completely 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 be 100% vested within 3-6 years.
Upon leaving the company, an employee should receive fair market value for their shares. For public companies, workers should receive voting rights on all issues. Private companies may restrict voting rights to such big issues as closing or relocating. Private companies also have to 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 procedure. 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 purchases more than 1/3 of those stocks in the company, the business can reinvest the profits on the sale in other securities and defer tax.
S corps don’t 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 in the fund may be taxed, though at potentially beneficial rates.
For all the advantages, however, there are a few drawbacks to the ESOP. ESOPs can’t be legally utilized in professional corporations or partnerships. In S corps, they do not qualify for rollovers and have lower limits on contributions. The share repurchasing mandated for private businesses 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 installation is only effective at fostering employee performance if employees have a say in decisions affecting their work. All of these are factors to take when determining if an ESOP is ideal for your firm.
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