An ESOP (Employee Stock Ownership Plan or Employee Share Ownership Plan) is a type of employee benefit plan that’s similar to profit sharing. With an ESOP, the company sets up a trust fund where it contributes new shares of its stock (or cash) to buy existing shares. It’s the most common form of employee ownership in the United States, covering an estimated 14.2 million people.
There are several reasons why a company may use an ESOP:
- To provide a market for owners who are departing closely-held companies
- To motivate and/or reward employees
- To take advantage of incentives for borrowing money to acquire new assets with pretax dollars
The Advantages of an ESOP
ESOPs offer the following advantages:
- Companies receive a tax deduction for contributing cash on a discretionary basis year to year. Cash contributions may also be used to purchase shares from the current owners or to create a cash reserve for the future.
- Contributions of stock are tax-deductible; companies receive a cash flow advantage by issuing new shares or treasury shares.
- ESOPs may borrow money to purchase existing shares, new shares, or treasury shares. ESOP financing uses pretax dollars, so contributions that are used to repay the loan are tax-deductible.
- ESOPs work with C- or S-corporations. With a C-corporation, sellers can reinvest the proceeds in other securities and defer any tax on the gain once an ESOP owns 30% of all shares in the company. In an S-corporation, the percentage of ownership held by ESOPs isn’t subject to income tax at the federal level (nor the state level, usually). This means there’s no income tax on 30% of an S-corporation’s profits, if it’s completely owned by its ESOP.
- Reasonable dividends used to repay an ESOP loan, whether passed through to employees or reinvested by employers in company stock, are tax-deductible.
- Employees don’t pay tax on ESOP contributions and can roll their distribution over into a retirement plan or pay current tax on the distribution with gains accumulated over time as capital gains tax.
If the income tax portion of the distributions is made before the normal retirement age, it’s subject to a 10% penalty.
The 2017 tax bill limits net interest deductions to 30% of EBITDA for four years; afterward, the limit decreases to 30% of EBIT. Businesses would subtract the depreciation and amortization before calculating the maximum deductible interest payments.
New leveraged ESOPs refer to companies that borrow an amount that’s large in relation to their EBITDA. These companies may find that their deductible expenses are lower, but the taxable income is higher. This won’t affect 100% ESOP-owned S-corporations because they are tax-exempt.
Limitations and Drawbacks
Although there are many advantages to ESOPs, there are some limitations and drawbacks to be aware of:
- ESOPs aren’t legally allowed to be used in partnerships or most professional corporations.
- Private firms are required to purchase shares owned by employees departing the company; this can be a significant expense.
- Setting up an ESOP can also be a significant expense. It costs approximately $40,000 to set up the simplest plans in small companies.
- An ESOP can improve a company’s performance, but only if it’s combined with the opportunity for all employees to participate in decisions affecting the company.
Other Things to Know About ESOPs
- In general, ESOP participation is open to all full-time employees over 21-years-old.
- Allocations are made using their relative pay or a more equal formula.
- Employees gain the right to acquire more shares based on their seniority and must be 100% vested within three to six years, depending on whether vesting is done all at once or gradually.
Once employees leave the company, they’ll receive their stock. The company buys the stock back at a fair market price, unless there’s a public market for it. Private companies will need an annual outside valuation to determine the share price. Although employees must be able to vote their allocated shares on major decisions, the firm can choose whether to pass through voting rights on minor issues. In a public company, employees must be allowed to vote on all issues.
With careful planning and guidance from our expert advisors, an ESOP may be the perfect choice for you and your employees. Please reach out to us for any questions you might have.