Does an Employee Stock Ownership Plan (ESOP) Make Sense for Your Company?

For some firms, an Employee Stock Ownership Plan (ESOP) could be an option.

An ESOP is an employee benefit plan that gives workers ownership interest in the company. The selling shareholder, as well as the participants in the plan, receive various tax benefits.

Companies often use ESOPs to align the interests of their employees with those of shareholders. The concept implies that plan participants will do what is best for shareholders, since the participants themselves are shareholders.

An ESOP is also a way to establish a transition plan by creating a market for the company’s stock. This way the company can sell the business gradually instead of exiting suddenly, even as it establishes an ownership culture within the company.

A company can sell stock to employees by:

Giving them shares as a bonus.
Allowing them to receive stock options.
Paying dividends in stock through a profit-sharing plan
Allowing them to buy company stock directly through ESOPs.

Tax Advantages to Starting an ESOP

Both plan participants and the company can get tax deductions with an ESOP.

When the ESOP borrows money to buy shares, the company can make tax-deductible contributions to the plan to repay the loan. Contributions to repay principal are deductible up to 25 percent of the plan participants’ payroll; however, interest is always deductible.

ESOPs don’t pay federal income tax, and employees don’t pay income tax on stock put into their ESOP accounts until they take distributions. However, they will have to pay a 10 percent penalty in addition to the income tax if they take a distribution prior to age 59 ½. They can avoid that penalty and defer taxes if they roll the money into an IRA or another qualified plan.

Employers who own a C-corporation and sell 30 percent or more of their stock to the ESOP can defer — or maybe avoid — the capital gains tax. However, the sales proceeds must be reinvested into stocks, bonds, or other securities of U.S. operating companies — but not into government bonds or mutual funds.

How to Start an ESOP

It’s critical to do a valuation before implementing a plan. Plus, a feasibility study will be needed if there is any doubt about the ESOP’s ability to repay the loan. An analysis can reveal how much extra cash flow the company has available to devote to the ESOP and whether it’s adequate. Employers must also consider the effect of other benefit plans on cash flow. And lastly, there should be an estimate of what it would cost to repurchase stock.

An employer should establish a trust to buy stock. The ESOP trust will own the stock and allocate shares to individual employee’s accounts.

A trustee must be chosen to oversee the plan. This can be someone from within the firm, but some private and most public companies hire an outside trustee.

Usually, all full-time employees age 21 and over have the option of participating in the plan. Allocations are usually based on an employee’s pay. Plus, as employees accumulate seniority, their right to exercise the full privilege of the shares in their account increases; a process known as vesting. Employees must be 100 percent vested within three to six years.

Employees get the stock after they leave the company, so the company must offer to buy the shares back unless there is a public market for them.

Drawbacks to an ESOP

The cost of setting up even a simple ESOP could be as much as $40,000 or more. Another cost to keep in mind is that any time a company issues new shares, the stock of existing owners is diluted. Plus, private companies must repurchase a departing employee’s shares, which could represent a major expense if a large number of workers all quit or retire at the same time.

The ESOP must pay no more than fair market value for company shares; so, as a transition plan, the principals of the employer will probably make more money by selling the company outright or taking it public.

Also, employers can only use an ESOP in C- or S-corporations, not partnerships or most professional corporations.

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