hr-guide.com

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?

Advantages
Disadvantages
  • 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?

What are the alternatives to ESOP?

Links