An ESOP, or Employee Stock Ownership Plan, is a method for companies 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 America, where more than 14 million people participate.
This form 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 stocks 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 businesses. ESOPs typically constitute the company’s investment in its employees, not a purchase by employees.
Rules and Structure
To establish 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, together with the firm contributing capital so the fund can repay the loan.
Corporate contributions are usually tax-deductible, although recent rules restrict 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 completely owned by an ESOP, which do not 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 known as”vesting.” The ESOP rules require all employees to become 100% vested within 3-6 decades.
Upon leaving the company, an employee should 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 relocating or closing. Private companies also have to have a yearly outside valuation to determine the value of their shares.
ESOP Tax Benefits
There are lots of tax benefits that ESOPs offer firms. Contributions of inventory 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 buy shares or develop 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 funding is in pretax dollars. In C corps, when the ESOP purchases more than 1/3 of those shares in the business, the company 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 from the fund may be taxed, though at possibly beneficial rates.
For all the advantages, however, there are a few 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 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 setup is only effective at boosting employee performance if employees have a say in decisions affecting their work. All of these are factors to take when deciding if an ESOP is ideal for your firm.
Learn more by visiting: https://www.delanceystreet.com/esop/