You may have heard of an Employee Stock Ownership Plan, or ESOPs. Is this a viable option for your business? There are a variety of factors to consider.
Employee ownership attracts job seekers. A survey of 1,500 Americans by Rutgers Institute found that 72% would like to work for an ESOP company. The survey also found consensus amongst Democrats, Republicans, and Independents that working for an ESOP company is preferable.
If you think it’s a good move for you, take some time to understand how ESOPs work and more important.
How Does it Work?
Generally speaking, ESOPs are contributions to the employee and not employee purchases. However, there are a few different routes employee ownership can take. Employees can buy stock directly, earn it as a bonus, receive stock options, or earn shares through a profit-sharing plan.
Many companies choose to set up an ESOP to reward and motivate their employees, perhaps after an owner departs. Also, there is an incentive to borrow money in pretax dollars. More on that later.
Think of it as an employee benefit plan. Companies set up a trust fund and contribute new shares of its stock or cash to buy existing shares. Also, the company may choose to take out a loan and make cash contributions to the plan to repay the loan.
Shares are allocated to each employee’s account. Usually, all full-time employees (over 21 years old) participate. The longer employees stay with the company, the more access they gain to the shares in their account, a process called vesting.
You can choose to do gradual vesting or all at once, but your employees must be 100% vested within three to six years. When an employee leaves your company, they receive their stock, and the company must repurchase it from them at the fair market value.
The ESOP empowers employees of private companies by including them in important decisions. For example, if you want to close or relocate your business, your employees must vote on this decision and many other issues.
Tax Benefits of an ESOP
There are some significant tax benefits for ESOPs. Company contributions to the ESOP trust are tax-deductible (within limits of 30% earnings before interest, taxes, depreciation, and amortization).
C-corporations can get a tax deferral and reinvest proceeds of a sale. S-corps enjoy the benefit of the ESOP percentage of ownership not being subject to Federal income tax.
Dividends used to repay an ESOP loan, or passed through to employees or reinvested in company stock are tax-deductible. Employees only pay tax, at a favorable rate, on the distribution of their accounts. Their contributions to the ESOP are tax-free.
So how does an ESOP affect retirement benefits? Some professionals argue that investing assets into a company stock is lousy news due to the lack of diversification. Plus, employees are now relying upon the company for their salary and retirement versus traditional arrangements.
Not to worry. Many ESOP companies have a secondary retirement plan or defined plan. Plus, the majority of ESOPs start to diversify assets over time. Therefore, ESOP employees are most likely better off, because now they have their diversified assets plus company stock.
It makes sense that ESOPs are likely to be more beneficial to younger employees and lower-income employees versus a traditional 401(k) plan. Employees of an ESOP company also enjoy better job security. According to Rutgers, employee share-owners are six times less likely to be laid off.
What’s the Catch?
Unfortunately, ESOPs cannot be used in partnerships and the majority of corporations. However, they can be used in S-corps, but do not benefit from rollovers. Also, private companies are forced to buy back shares from employees who leave, and that can add up to a significant amount.
Another major consideration is the cost to get your ESOP setup. Generally, a private company is looking at around $40,000 or more for a simple plan.
The caveat is that ESOPs can work wonders for employees and employers. However, an ESOP is only truly effective when your employees have opportunities to participate in decisions about the company and their work. This is probably one of the most significant incentives, and the reward is a loyal and motivated team.