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 through private or public stock shares. When implemented properly, employee stock ownership has benefits for employee compensation, tax obligations and your company culture.
This is where ESOPs become important. What is an ESOP, and what does ESOP stand for? Simply put, an ESOP is an Employee Stock Ownership Plan. The advantage of these is that they create a well-defined structure for your financial strategy toward employee stock ownership and better alignment between the staff’s and employer’s financial goals.
 
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What is an ESOP?

To clearly define ESOP: 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 these shares’ growth in value over time. ESOPs are qualified plans with defined contributions, meaning they meet the IRS standards for receiving special tax exemptions and benefits.
 
Let’s answer the question, “what is an employee stock ownership plan?” and explore the meaning of ESOP in more detail. ESOPs let employees accumulate company stock throughout their time at the company and trade these shares for their cash value once they leave or retire. The employer can then redistribute those stocks to other employees as needed or use them for new ESOPs as part of their recruiting strategy.
 
ESOPs involve only a portion of the company’s overall stock offerings, connecting an employee’s motivation at work with financial success without having to negatively impact company management, share-based voting power or administrative structure. Business owners can, however, also use an ESOP to redistribute voting shares that control the business, deciding when and if they want to put certain types of voting shares of the company into employee hands through an 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 then 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 predetermined 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, pay grade, length of employment or 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

ESOPs offer numerous benefits to both employers and employees. For employers, their advantages cover administrative control, tax planning and financial health. Here are some key benefits of these employee stock ownership plans:
 

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. This creates a sense of continuity because shares are regularly redistributed to employees as people leave. Because these employees have a stake in the company’s well-being, they’re more likely to act in line with its benefit.
 

Lower turnover

A long-term benefit of ESOPs is that they financially encourage staff longevity in a company that uses them. By having your employees and management committed to the company through share ownership, you give them a strong reason to stay so that the value of these shares increases. This can improve loyalty and reduce turnover to save the company money on recruiting, hiring and training new staff.
 

Tax advantages

ESOPs can be used to create multiple kinds of tax deductions in a company. Contributions of stock to an ESOP are tax-deductible, allowing the company leadership to gain a cash flow advantage through new stock. Furthermore, cash contributions to the ESOP trust can also be tax deducted regardless of whether these contributions are used to buy back shares or to remain as cash reserves for future needs. Dividends and loan repayments are also tax-deductible through ESOPs.
 

Creating a share market

Business owners can use the creation of an ESOP to maintain a stable market for shares in their company. With this, the company can issue new shares to employees as needed for the sake of gaining funds or buy them back through tax-deductible loans and cash payments. Owners can also shift their control of the company toward employees as desired by increasing employee ownership, thus slowly blurring the line between employee and employer.
 

Additional loyalty benefits for employees

Employers can use an ESOP to issue shares as part of an employee savings plan. By matching their employees’ savings contributions in stocks from the ESOP instead of cash, owners and employers can often contribute to employee benefits at a higher-than-normal level. This also allows company owners to save cash for other uses.
 

How ESOPs benefit your employees

ESOPs can also bring direct benefits to your employees in ways that improve their morale and reduce certain costs to you as an employer:

  • Delayed taxation: Much like a 401(k), Employee Stock Ownership Plans allow workers to not pay taxes on the value of their ESOP contributions 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 motivated to see their employer succeed because they directly own a value-accumulating part of 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. They do this by regularly contributing additional funds directly to the unleveraged ESOP. 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 partly or wholly through borrowed funds. They can utilize the money from a lender to buy back shares from stock-owning employees as they retire or leave, and 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.
 

Which 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 often work best for midsize businesses that can afford the hefty investment of setting up a stock ownership plan. If a business is too small, an ESOP could provide unnecessary financial strain on its finances because even small company ESOP planning typically requires $40,000 or more in expenses. It 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, Stock Ownership Plans are not ideal for companies with already established succession planning, such as those with 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 usually 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 at a minimum will require $40,000 for their creation. 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 and make sure that the tax information you do receive is legally up to date.
  • 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 employees and exist as a way for closely held companies to use their stock options to incentivize their workforce.

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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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