An Employee Stock Ownership Plan is a way for employees of a company to have partial, or sometimes full, ownership of a company. This plan differs from a cooperative in that ownership is bestowed in the form of stocks, by buying stocks directly, obtaining stocks through a profit-sharing plan, or in the form of a bonus. In a cooperative, all the company owners have an equal say in control of the company. That is generally not true in an ESOP.
ESOPs have become a significant majority of employee ownership in the United States. Very rare just two generations ago, ESOPs are now popular with more than 6,500 plans in existence covering more than 14 million employees.
While it is rare for an ESOP to be used as a means to rescue a company from peril, there are several more common reasons for its deployment. Those include:
• to provide a market for shares
• to take advantage of tax incentives
• to reward employees
Those tax benefits are numerous, including but not limited to:
• new shares of stock issued, money repaid to a loan, and cash contributions to an ESOP are tax deductible
• dividends are also tax deductible
• in an S corporation, the percentage of ownership is not taxable on the federal level
• Only the distribution of the ESOP accounts are taxable, not the contributions, and even then are taxed at favorable rates
The rules for an ESOP are similar to those for an employee benefit plan or profit-sharing plan. A company establishes a fund for an ESOP, and contributes cash or new stock shares to buy existing company stock shares. Also, the company may borrow money to buy these shares. When that happens, the company then makes cash contributions to the ESOP to pay for the loan.
Companies use a formula to determine the allocation of shares in the ESOP trust. Generally this benefit goes to full-time employees over the age of 21. A formula is used for the precise allocation, often based on pay. As they accrue seniority with the company, employees have a right to more shares in the ESOP increase. This is called vesting, which usually must be completed within three to six years.
If an employee leaves the company, he or she will get their stock shares, which are then bought by the company at a value determined by the market.
While there are many benefits to both a company and its employees, ESOPs are not without their downsides. An ESOP can be used in an S corporation but without all the tax benefits. And ESOPs are not allowed at all for partnerships. When a company is forced to buy shares from a departing employee, this can be costly. Also, setting up an ESOP can be expensive. And since and ESOP means the issuance of new shares, that will result in a dilution of shares for existing owners. And while many ESOPs are appealing to employees, that benefit loses its luster if the employees are not allowed to take part in decision-making.