What is an ESOP?
An Employee Stock Ownership Plan (ESOP) is a tax-qualified defined contribution retirement plan that primarily invests in the sponsoring company’s stock. ESOPs are primarily used to provide a market for the shares of a departing owner. Through the creation of an ESOP, the departing owner, the company, and plan participants can receive substantial tax benefits.
ESOPs were relatively unknown until 1974 with the passage of ERISA. They are qualified retirement plans, similar to profit sharing plans, which must invest “primarily” in company stock. They are typically funded by employer contributions, not employee deferrals. ESOP’s may also be leveraged where a loan is involved, or non-leveraged. The spectrum of ESOPs covers Fortune 500 companies to small, private firms and now, due to their growing popularity, more than 6,700 companies have ESOPs covering 13 million employees.
An ESOP provides a ready market for the shares of a departing owner of a successful closely-held company. ESOPs allow for the preservation of management and culture of a company as well as motivating and rewarding employees. They create an additional employee retirement benefit and plan sponsors can borrow money at a lower after-tax cost (in the case of a leveraged ESOP).
1. Employer contributions of cash or stock are tax-deductible.
2. C corporation dividends are tax-deductible, under certain circumstances.
3. Employees pay no tax until their accounts are distributed.
4. An ESOP’s share of an S corporation’s income is not subject to federal income tax.
5. C corporation owners can defer taxes on the sale of the company under IRC Section 1042, if certain conditions are met.
6. There is the potential for improved corporate performance through employee motivation and inclusion, where a strong employee-owner culture is fostered.
How an ESOP Operates
An employer contributes cash to the ESOP to buy shares, or stock can be contributed directly. Alternatively, with a leveraged ESOP, money is borrowed to buy a large block of shares from the owner. The employer then makes cash contributions to the ESOP to repay the loan, which in turn releases shares into participant accounts over the term of the loan. An independent stock valuation is required for private companies.
When employees retire or terminate employment, they receive the cash value of their shares at the current fair market value. Participants must “vest” within 3 to 6 years (either “all at once” or on a graded schedule). Distributions to former participants may be delayed and paid in annual installments to help the employer spread out the ESOP’s repurchase liability. Participants also must have the right to diversify a portion of their stock at certain prescribed times, and employees must be able to vote their allocated shares on certain major corporate issues in private companies.
Departing employees must have the right to require the company to buy their stock back at fair market value so corporate cash flow needs must be monitored. ESOP implementation can be costly, but is probably comparable to selling to an outside buyer. Lastly, if new shares are issued, the stock value for existing owners is diluted and this must be weighed against tax and employee motivation benefits.
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