Employers offer a variety of benefits to retain current employees and to attract new employees. Giving employees some ownership of a company is a common benefit that also acts as an incentive. It helps to reduce employee turnover, and it motivates employees to make sure the company succeeds. Stocks are frequently used to give employees some ownership of a company, and a popular way to do this is through an Employee Stock Ownership Plan.
What’s an ESOP?
An ESOP is a type of profit-sharing benefit plan that gives employees an ownership interest in a company. A key component of an ESOP is the establishment of a company trust fund. A company can place its stocks in this trust fund, or it can place cash into this trust fund to purchase new shares of stocks. When cash is used from the trust fund to purchase shares of stock, it is considered a loan. The company must put cash back into the trust fund to pay back the loan.
Around 14 million employees participating in roughly 7,000 ESOPs according to the National Center for Employee Ownership. Several million more employees participate in some other form of individual equity plans that are like ESOPs. It is estimated that eight percent of corporate equity is now controlled by employees.
How does an ESOP work?
Employees can participate in an ESOP if they are full-time employees and are at least 21 years old. When an employee sets up an ESOP account, the employer can start depositing shares of stock into the employee’s account. The number of shares that are deposited into the account depends on certain factors such as the employee’s pay rate and seniority. An increasing number of shares are deposited into the employee’s account as they gain more seniority. This is known as vesting, and an employee must be 100 percent vested at some point within six years of creating an ESOP account.
When the employee leaves the company, their former employer buys back the shares at fair market value if the company is private. An outside evaluation must take place to determine the fair market value of the shares. If the company is public, then the former employer buys back the shares at the price that is stated in the stock market.
ESOP tax benefits
An ESOP provides tax benefits to both the employer and employees. Employer benefits include tax deductions or tax deferrals for:
• Stock and cash contributions
• Loan repayment contributions when the loan was taken out of the ESOP for any purpose
• C-corporations who own at least 30 percent of all company shares
Under certain circumstances, an S-corporation does not have to pay federal or state income taxes on 30 percent of the profits when an ESOP holds at least 30 percent of the company’s stock.
Employees also receive tax benefits from having an ESOP account. Employees do not have to pay taxes on the contributions they make to an ESOP. The accumulated gains in the ESOP are not subject to a capital gains tax. Distributions made after retirement age receive favorable tax treatment. Distributions made before retirement age are subject to a ten percent penalty. Businesses and employees who have an ESOP should seek professional tax advice on the tax benefits of having this type of plan.