What is an ESOP (Employee Stock Ownership Plan)?

Many companies compensate and motivate their employees by giving them the opportunity to own part of the company. When implemented properly, employee stock ownership has benefits for both tax obligations and the company culture. Employee Stock Ownership Plans have a well-defined structure that helps you to make your financial strategy for shareholders better connect with employee actions.

 

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What is an Employee Stock Ownership Plan?

An Employee Stock Ownership Plan or ESOP is an employment benefit that allows a company’s employees to own shares in the business and benefit from their appreciation in value over time. ESOPs are qualified plans with defined contributions, meaning they meet the IRS standards to receive special tax exemptions and benefits.

 

ESOPs let employees accumulate company stock throughout their time at the company and earn their cash value once they leave or retire, leaving the employer to redistribute stocks to other employees. ESOPs involve only a portion of the company’s overall stock offerings, connecting an employee’s motivation at work with financial success without impacting the company management or structure. Business owners can also use an ESOP to redistribute voting shares that control the business, deciding when and if they want to put voting shares of the company into the ESOP.

 

How do ESOPs work?

When a business sets up an ESOP, they establish a trust to act as a separate legal entity to hold shares of company stock. The company either directly deposits money into the trust,  takes out a loan to fund the trust or uses a combination of profit and borrowed money. The trust then purchases a pre-determined number of shares directly from the company or buys them back from outside or public buyers.

 

Once the trust has purchased company shares, they distribute them to employees based on their contribution to the company, either through their pay grade, length of employment or using another equitable formula. Employees generally receive more stocks as time goes on, much like a regular retirement account that grows with each employer contribution. If the employee leaves the company or retires, they sell their stocks back to the trust. The trust then uses those stocks to compensate employees that qualify for the ESOP plan, keeping company ownership within a core group of employees over time.

 

Benefits of having an ESOP for your business

Consider these benefits associated with providing an ESOP to your staff:

 

Preserving the company

Allowing an outside trust to manage shares that are exclusively available to employees helps ensure that your business will continue running even after company leadership retires. It creates a sense of continuity because shares are regularly redistributed to employees as people leave.

 

Lower turnover

As a long-term benefit, ESOPs encourage companies to develop longevity at their current employer. This can improve loyalty and reduce turnover to save the company money on recruiting, hiring and training new staff.

 

Motivation

When employees own stocks in their employer, it gives them an incentive to work hard to grow the company’s value. It can help people see the direct impact of their work when the stock grows in value, improving morale and dedication for qualified employees.

 

Tax benefits

The money and stocks you contribute to an ESOP is tax-deductible up to a certain value. Dividends and loan repayments are also tax-deductible.

 

How ESOPs benefit your employees

ESOPs can also bring direct benefits to your employees:

 

  • Delayed taxation: Much like a 401(k), employees don’t have to pay taxes on the value of their ESOP until they retire or cash out their plan.
  • No-cost retirement planning: Employees do not have to pay anything to accumulate shares of company stock.
  • Empowerment: An ESOP can help employees feel more excited about their work and empowered to succeed because of their ownership in the company.

 

Types of ESOPs

There are three main structures for ESOPs:

 

Unleveraged

Employers directly fund unleveraged ESOPs, also known as non-leveraged ESOPs, without borrowing money. Employers regularly contribute additional funds to unleveraged ESOPs. When the sponsoring company issues new shares of stock, they take a deduction for the market value of the stock they contributed to the ESOP.

 

Leveraged

Leveraged ESOPs are plans that companies develop using borrowed funds. They use money from a lender to buy back shares from stock owners, then pay back the loan over time instead of making direct contributions.

 

Issuance

Issuance ESOPs involve adding new shares of stock to the trust. Instead of contributing cash, the sponsoring business dilutes the value of current shares to increase the number of stocks they can offer to new and existing employees.

 

What companies should and shouldn’t use ESOPs

Like any retirement plan, ESOPs aren’t a perfect fit for every company. When deciding whether to implement an ESOP at your business, consider these factors:

 

  • Size: ESOPs work best for mid-sized businesses that can afford the investment of setting up a stock ownership plan. If a business is too small, an ESOP could provide unnecessary financial strain on the businessIt could also be logistically challenging if the business doesn’t have many employees. Additionally, large companies may not be able to fairly distribute shares to all employees.
  • Value: If your company already has a high value, ESOPs can be extremely expensive. Highly-valued stock will cost more in an ESOP than stock with a lower market value.
  • Ownership structure: While ESOPs are a great way to pass ownership to other employees, ESOPs are not ideal for companies that have a planned succession, such as owners of family businesses who want to transition ownership to a relative.
  • Exit strategy: If you want to sell your business for a profit, ESOPs can be a deterrent to potential buyers because they will have to buy out the trust. ESOPs are better for companies that don’t plan on being acquired as an exit strategy.

 

Tips for setting up an ESOP at your company

If you’re thinking about establishing an ESOP as a benefit at your business, consider following these steps:

 

  • Assess cost: Before committing to an ESOP, make sure you understand the costs associated with providing this benefit. ESOPs can cost over $80,000 to set up and $20,000 or more each day, so you should research the specific costs associated with your needs.
  • Research ESOP rules: The IRS has rules about contribution limits, vesting requirements and administration. Familiarize yourself with these requirements to limit your liability.
  • Select a provider: Research various ESOP providers to help set up and administer your trust. Hiring an outside provider will help ensure that you remain compliant and provide ongoing support for the plan. 

Frequently asked questions about ESOPs

How does an ESOP work?

ESOPs work by having an outside business entity govern part of a company’s stock and systematically sharing it with employees.

Is an ESOP the same as a 401(k)?

ESOPs are different from 401(k)s. They use stock contributions instead of cash to provide employees with a long-term retirement benefit.

How much does an ESOP cost employees?

They generally cost nothing to the employees and exist as a way for closely-held companies to use their stock options to incentivize their workforce.

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