Compensation: Incentive Plans: ESOP
Employee Stock Ownership Plan (ESOP)
An ESOP is a defined contribution employee benefit plan that allows employees to become owners of stock in the company they work for. It is an equity based deferred compensation plan. Several features make ESOPs unique as compared to other employee benefit plans. First, only an ESOP is required by law to invest primarily in the securities of the sponsoring employer. Second, an ESOP is unique among qualified employee benefit plans in its ability to borrow money. As a result, "leveraged ESOPs" may be used as a technique of corporate finance.
How does ESOP work?
- The ESOP operates through a trust, setup by the company, that accepts tax deductible contributions from the company to purchase company stock.
- The contributions made by the company are distributed to individual employee accounts within the trust.
- The amount of stock each individual receives may vary according to pre-established formulas based on salary, service, or position.
- The employees may "cash out" after vesting in the program or when they leave the company. The amount they may cash out may depend on the vesting requirements.
- When an ESOP employee who has at least ten years of participation in the ESOP reaches age 55, he or she must be given the option of diversifying his/her ESOP account up to 25% of the value. This option continues until age sixty, at which time the employee has a one-time option to diversify up to 50% of his/her account. This requirement is applicable to ESOP shares allocated to employee's accounts after December 31, 1986.
- Employees receive the vested portion of their accounts at either termination, disability, death, or retirement. These distributions may be made in a lump sum or in installments over a period of years. If employees become disabled or die, they or their beneficiaries receive the vested portion of their ESOP accounts right away.
- Capital Appreciation. Companies sell some or all of their equity to employees and by doing so convert corporate and personal taxes into tax-free capital appreciation. This allows the owner to sell 100% of his or her company, get money out tax-free and still maintain control of the company.
- Incentive Based Retirement. Provides a cost-effective plan to motivate employees. After all, who works harder, owners or employees?
- Tax Advantages. Enables tax advantaged purchasing of stock of a retiring company owner. With this purpose, a company owner may sell their shares to the ESOP and incur no taxable gain on the sale. A company owner can sell all or some of the company to the employees cost free. Owners who sell 30% or more of their company to an ESOP are allowed to "roll-over" the proceeds into other securities and defer taxation on the gain.
- Company reduces it's tax liability. A company can reduce its corporate income taxes and increase its cash flow and net worth by simply issuing treasury stock or newly issued stock to its ESOP.
- Dilution. If the ESOP is used to finance the company's growth, the cash flow benefits must be weighed against the rate of dilution.
- Fiduciary Liability. The plan committee members who administer the plan are deemed to be fiduciaries, and can be held liable if they knowingly participate in improper transactions.
- Liquidity. If the value of the stock appreciates substantially, the ESOP and/or the company may not have sufficient funds to repurchase stock, upon employees' retirement.
- Stock Performance. If the value of the company does not increase, the employees may feel that the ESOP is less attractive than a profit sharing plan. In an extreme case, if the company fails, the employees will lose their benefits to the extent that the ESOP is not diversified in other investments
What is the best way to implement ESOP?
- Determine how you want to use the ESOP. Will it be used as an employee benefit plan? Or, as an incentive program?
- Conduct a feasability study to determine the value of the company's stock and impact of the contributions that must be made to the trust.
- An ESOP requires different accounting procedures and a different method of allocating stocks and other investments among the employees than other types of plans. For this reason the plan should be designed by an ESOP specialist in order to avoid IRS difficulties.
What are the alternatives to ESOP?
- Employee stock options.
- Profit Sharing. An ESOP differs from a profit sharing plan in that an ESOP is required to invest primarily in employer securities, while a profit sharing plan is usually prohibited from investing primarily in employer securities.