Pension plans and employee stock options are both common—and often effective—strategies to engage employees and motivate them to help the business succeed. In private companies, however, offering stocks to employees through traditional options isn’t as straightforward, which is where employee stock ownership plans (ESOPs) come in. ESOPs allow companies to remain closely held while offering the benefits of employee stock compensation.
Although ESOPs are a common benefit plan option, they vary significantly from company to company and they aren’t necessarily simple to set up correctly. Therefore, it is important to consult a corporate securities lawyer before setting up any ESOP. Priori Legal makes it easy for you to find an excellent benefits and corporate securities lawyer you trust, so that you can implement a compliant ESOP.
Understanding Employee Stock Ownership Plans
An employee stock ownership plan (ESOP) is a defined contribution, employee benefit plan designed to invest primarily in the stock of the sponsoring company. Essentially, an ESOP works to reward and motivate employees through contributions in a retirement plan matched by stock. Generally, these plans are similar to profit-sharing plans.
How ESOPs Work
ESOPs are set up as a trust fund created by the sponsoring company through contributions of stock or cash intended to buy shares. Generally, each full-time employee is allocated shares within this trust relative to their pay and seniority. These shares vest over a period of time, generally three to six years.
When an employee leaves the company, the shares are turned over to them, and the company must buy back the shares at a fair market value. Until an employee leaves the company, they are generally given voting rights (with private companies, this is a requirement).
When ESOPs Are Used
There are a few key situations in which ESOPs are used by companies. The most common reason is to create a ready market for a departing owner’s shares in privately held companies. This allows control of the company to remain internal and confers tax-benefits on the sale of these shares. Other companies utilize ESOPs as a way to borrow money at a lower tax rate. Still other companies use ESOPs primarily to confer employee benefits, often in conjunction with an employee savings plan.
ESOPs and Tax Considerations
As with anything related to tax, it’s crucially important to work with a lawyer to understand the impact of an ESOP from a tax perspective on your company and unique situation. In general, ESOPs are considered to be advantageous from a tax perspective to both the company and the employee. The following are the tax benefits generally associated with employee stock ownership plans:
Contributions of stocks and cash to ESOPs are tax deductible, including those used to pay off a loan.
In S-corporations, the percentage of ownership held by the ESOP is not subject to income tax.
Sales of ESOP shares in a C-corp are tax-deferrable.
ESOP dividends are tax-deductible.
Employees pay no tax on the contributions to the ESOP.
ESOP distributions rolled into a retirement plan are taxed at the capital gain rate.
The trust itself is tax-exempt.
Advantages of Employee Stock Ownership Plans
For many companies, there are significant advantages to setting up an ESOP, including:
Tax Advantages. The tax advantages generally accrue to both the company and employees.
Higher Employee Morale. Like other forms of employee stock ownership, ESOPs are a way of incentivizing employees to perform by allowing them to share in the economic upside.
Strong Retirement Plan. ESOPs often represent a strong retirement plan option.
Disadvantages of ESOPs
There are, however, disadvantages of ESOPs for some companies, including:
High Setup Costs. Setting up an ESOP requires significant time and expense, even for relatively small companies.
Potentially High Cost of Share Repurchases. Companies are obligated to repurchase the shares of employees leaving the company -- and because companies can’t always control the timing of these departures, companies may face significant repurchase costs if employees opt to leave at similar times.
Dilution. All other things equal, if many new shares are issued, the stock of existing owners is diluted.
Records Requirements. Because ESOPs require detailed periodic records, disclosures, and reports, administration can be expensive -- and potentially difficult to manage.
Can every company take advantage of an ESOP?
To some extent, yes. Generally, however, privately held C-corporations are best positioned to take advantage of ESOPs.