An ESOP, or Employee Stock Ownership Plan, is a method for businesses to provide their employees shares of ownership. It can be achieved in many different ways: by giving employees stock options, by providing inventory as a bonus, by enabling workers to buy it right, or through gain sharing. There are now almost 7,000 ESOPs in the usa, where more than 14 million individuals participate.
This kind of stock ownership plan can serve a number of purposes. They can be utilised as a means to motivate workers, 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 provider’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 buy shares of stock or new stocks issued by the company. The fund may also borrow money to buy shares of stock, together with the company donating funds so the fund can pay back the loan.
Corporate contributions are usually tax-deductible, although current rules restrict 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 greater, except for S-corps which are entirely owned by an ESOP, which do not pay any taxes.
While typically all fulltime adult employees take part in the plan, shares are usually 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 workers to become 100% vested within 3-6 decades.
Upon leaving the business, an employee should receive fair market value for their shares. For public companies, workers must receive voting rights on all issues. Private companies may restrict voting rights to such big problems as relocating or closing. Private companies also have to have a yearly outside valuation to ascertain the value of their stocks.
ESOP Tax Benefits
There are lots of tax benefits that ESOPs provide firms. Contributions of inventory are tax-deductible, as are gifts of money. Companies can issue new shares of stock or treasury to the ESOP to create 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 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 buys more than 1/3 of those stocks in the business, 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 aren’t taxed. Employee gains in the fund may be taxed, though at possibly favorable prices.
For all the benefits, however, there are a few drawbacks to the ESOP. ESOPs can’t be legally utilized in professional partnerships or corporations. In S corps, they do not qualify for rollovers and have lower limits on donations. 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 program participants, and the installation is only good at fostering employee performance if workers have a say in decisions affecting their work. All of these are factors to consider when determining if an ESOP is ideal for your firm.