Understanding ESOPs (Employee Stock Ownership Plans)

One way to sell your business or to plan for succession is to offer employees stock through an ESOP (Employee Stock Ownership Plan). In addition to being a way to sell or retire from a business, ESOPs offer many other benefits.

In 1974, when federal legislation made ESOPs possible, about

Key Elements of an ESOP:

• An ESOP is essentially a tax-qualified employee profit-sharing program. It invests primarily in the employer's stock and it may own a small percentage of the stock or all of it.
• All of the stock in ESOP is held in trust.
• The company can contribute cash to the ESOP to buy shares, or the ESOP can borrow money to buy shares, and then the company makes cash contributions to the plan, which the ESOP then uses to pay back the loan.
• An ESOP is the only kind of employee benefit program that can borrow money.
• Shares can be allocated using a variety of factors, such as seniority and pay scale.
• Usually only full-time employees may buy shares.
• Dividends are paid to employees in the form of cash or increased value of the stock.
• Company contributions to the plan are tax deductible, within certain limits.
• Over time, each employee gains more complete ownership of his or her stock and must become fully vested in five to seven years.
• When an employee leaves, the company must buy back the shares at fair market value.

Advantages of ESOPs:

• ESOPs can increase employee incentive. People work harder and are more loyal when they own part of the company. Studies have shown a high correlation between employee ownership and productivity.
• ESOPs can be used to prevent a company shutdown by raising money and increasing the employees' desire to be more productive.
• A retiring owner who sells more than 30 percent of the stock in a closely held corporation can defer capital gains if the proceeds are used to invest in other securities.
• They create a market for an owner's shares.

Tax Advantages of ESOPs:

• ESOPs offer great tax-advantaged borrowing. When a company uses an ESOP to borrow money to purchase stock, the company can use the cash for any legitimate purpose. Both the principal and interest payments are deductible.
• Dividend payments in cash are tax deductible.
• Individual ESOP accounts are tax sheltered until the employee retires or leaves the company, at which point the shares must be sold.

Disadvantages of ESOPs:

• ESOPs cannot be used in partnerships and most professional corporations. They can be established in S corporations, but do not qualify for certain "rollover" advantages of other employee programs.
• As mentioned above, companies must repurchase the shares when an employee leaves. In some cases, this may mean huge cash outlays.
• They can be expensive to set up.
• Whenever new stock is issued, the value of the owner's stock becomes diluted.

Employee Power and Success

Although ESOPS can offer a great exit strategy for owners, their impact on a company can be broad. That is why your decision to create an ESOP must consider other factors besides your retirement.

If your company creates an ESOP, higher employee participation is not only beneficial; it's mandatory. In private companies, employees must be allowed to vote on major issues, such as opening or closing a plant. In public companies, employees must be able to vote on all issues.

So keep these factors in mind when considering an ESOP and be sure to consult with your tax advisor and legal counsel before creating one.