February 7, 2022

ESOPs: The Basics of Employee Stock Ownership Plans

By Bart Zandbergen CFP

A company that wants to supplement its employees’ salary with equity compensation can do so in a variety of ways. The most popular is the employee stock ownership plan (ESOP). Besides offering employees a potentially valuable ownership stake in the company, ESOPs can play an important role in succession planning and confer tax advantages to employers. 

What is an employee stock ownership plan?

An ESOP is essentially a trust fund. A company can deposit newly issued shares into the fund, as well as money used to buy existing shares. Employees participating in the ESOP each receive accounts. While keeping shares inside the trust, the ESOP allocates them to employees based on a formula that may take pay level and seniority into account. 

These shares may “vest” over time, meaning that employees have to work with the company for several years before acquiring shares, and they may own more shares the longer they work. Any dividends paid directly to shareholders are tax-deductible for the employer and taxed as income for the shareholder.

ESOP rules ensure that employees have equal access to the plan and are treated fairly. With few exceptions, an ESOP must be open to all full-time employees over the age of 21. Employees must gain voting rights equal to the number of shares they own on some or all company issues.  

When an employee leaves their job, the ESOP buys back all of their shares at market value, meaning they walk away with a cash payout equal to the value of the shares they own. This payout can come as a lump sum or as a series of substantially equal payments over a period of time. If the employee leaves before the vesting period has ended, they forfeit any unvested shares.

When an individual cashes out their ESOP shares, they pay ordinary income tax on the distribution(s) they receive. If under age 55, they’ll be charged an additional 10% excise tax unless they roll over their ESOP balance to a tax-advantaged retirement account, such as an IRA or 401(k). 

Benefits of an ESOP

Some people advocate ESOPs because they have an ideological commitment to employee ownership. Outside of this, ESOPs have several specific advantages:

  • Recruitment and retention. As a type of qualified retirement plan and equity compensation, ESOPs can sweeten a job offer and attract employees, particularly for companies that expect to grow over the long term. As shares typically vest over time, an ESOP can also act as an incentive for workers to stay with a company until they receive the full benefit of their ESOP. As with other employee ownership schemes, the employer’s hope is that an ownership stake will motivate employees to work hard to help grow the business, as they stand to benefit from its long-term success.
  • Succession planning. As a trust fund that can hold cash and company stock, an ESOP is a popular succession planning tool. Outgoing owners without a ready buyer can sell their stake to the ESOP, either gradually or all at once. The company can buy the shares with tax-deductible cash contributions or through a loan taken out by the ESOP. 
  • Tax-advantaged borrowing. When an ESOP borrows money, the loan is repaid by the company through tax-deductible contributions to the trust fund. That means the company avoids taxes on both principal and interest. It’s possible to use ESOP borrowing to finance expansions, acquisitions, spin-offs, and other projects.

As a retirement benefit, ESOPs are virtually unique in asking for no employee contribution in most cases. As a buyer for an outgoing owner’s shares, ESOPs can keep businesses afloat that might otherwise have folded. As a financing tool, ESOPs offer tax-deductible borrowing. 

Establishing an ESOP is a multistep process that includes a feasibility study, a valuation of the business, and the help of an attorney in drafting the plan, but depending on the needs of the business, it can be a powerful, multiuse tool.

SOURCES:

https://www.esoppartners.com/blog/how-is-esop-taxed-when-distributed

https://www.nceo.org/articles/esop-employee-stock-ownership-plan

https://employeeownershipfoundation.org/articles/what-is-an-esop

https://www.wcl.american.edu/academics/experientialedu/clinical/theclinics/elc/tlcc/for-businesses-nonprofits/esops-info-sheet/

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