Employee Stock Ownership Plans (ESOPs) are beneficial for both companies and employees. Some of the ways in which employees buy stock is through direct purchase, profit sharing plans, a bonus given by the employer and worker cooperatives. However, ESOPs are the most prevalent way in which employees acquire stock and they have been doing so for decades.
There are many reasons why ESOPs are beneficial. Despite what some report, they are rarely used to rescue companies on the brink of disaster. The reason why this is believed is because the plan offers the benefit of allowing companies to borrow money and make ESOP contributions to pay it back. While this is an authorized use, it’s not something that occurs with any amount of frequency. There happens to be many uses that are beneficial to both companies and employees.
ESOPs are often used to both reward and motivate employees. Another common use is when a successful company is closely held and an owner departs. An ESOP essentially provides a market for their shares. This type of plan also offers tax incentives when used to borrow money for the purpose of obtaining new assets.
Overview of ESOP Rules
There was a tax bill in 2017 that limited the net interest deductions for companies to 30 percent of earnings before interest, taxes, depreciation, and amortization (EBITDA). This is for a period of four years, after which the limit is on earnings before interest and taxes (EBIT). This bill goes into effect in 2022 and the change will possibly increase the amount of income that’s taxable when a company borrows money from an ESOP.
Employee shares of an ESOP are placed in an individual employee account and they are fully vested within a period of three to six years. There are some instances when vesting occurs at one time as opposed to on a gradual basis. Upon the employee’s departure from the company, their stock is bought back based on the fair market value. This is assuming there isn’t a public market. A benefit of an ESOP is that employees can vote on major issues in private companies and they can vote on all issues in public companies.
Overview of ESOP Uses
ESOPs are used to buy the shares of an owner that’s departing. The company can borrow money to buy the shares or they can make cash contributions that are tax deductible to buy them. The ability to borrow money to buy back shares is what makes ESOPs unique. When this happens, a tax-deductible contribution is made to pay back the loan and both the interest and principal are deductible.
ESOPs create an employee benefit by enabling the company to issue shares or contribute cash. In fact, it’s common for ESOPs to be used along with employee savings plans. When that happens, the employer will often match the savings with stock instead of cash.
Significant Tax Benefits
There are many ways in which companies receive tax benefits for establishing an ESOP. For starters, stock contributions are tax deductible, which provides a cash flow. Cash contributions area also deductible. There are tax deferrals for C corporations and S corporations. It’s also worth noting that employees don’t pay taxes on contributions to the plan.
While there are many benefits associated with participation in an ESOP, there are also drawbacks. For instance, they cannot be used in a partnership and there are significant costs for setting up the plan. Nevertheless, the advantages are weighty and ESOPs can actually improve the performance of a company when employees participate.