Employee Stock Ownership Plans (ESOPs) Employee stock ownership plans (ESOPs) are tax-qualified defined contribution retirement plans designed to provide employees with an ownership stake in the company where they work. ESOPs are distinct from other qualified benefit plans in several respects. Unlike most defined contribution retirement plans, which are required to be invested in a diversified portfolio, ESOPs are intended to be invested primarily in company stock. In addition, ESOPs can borrow money to purchase a large block of company stock and pay for it over time through tax-deductible corporate contributions. ESOPs also enjoy substantial tax advantages including corporate tax deductions for both principal and interest payments on ESOP loans, a deferral or total avoidance of capital gains for stock sold to an ESOP by owners of privately-held companies, and tax deductions for dividends paid on ESOP stock.
ESOPs may take one of two forms:
The non-leveraged form is a tax-qualified retirement savings plan designed to invest primarily in the stock of the sponsoring corporation. With this plan, the company makes a contribution to the ESOP each year on behalf of its employees, much as a company would contribute to a pension plan. The contribution can be made in stock (which improves company cash flow because it requires no cash outlay and, in addition, generates a tax deduction for the fair market value of the contributed shares), or it can be made in cash that is then used by the trust to purchase company stock or simply allocated to the accounts of the employees. The stock acquired by the plan is allocated to individual accounts maintained for each participating employee.
A leveraged ESOP is a powerful financial tool that not only grants equity ownership to a company's employees, but can simultaneously provide important advantages to the company and its current owners. These advantages include:
- Owners can gain liquidity for their privately held stock on tax-advantaged terms
- Principal repayment of the ESOP debt by the corporation is tax deductible
- Subsidiaries or divisions can be divested by selling them to the employees
- Mergers and acquisitions can be accomplished on tax-favored terms
Without a doubt, the most common reason behind the choice of a leveraged ESOP for creating employee ownership is to buy out existing owner(s) through a tax-advantaged transaction. Briefly described, the sale of stock to employees through an ESOP involves four basic steps, as follows:
Step One: The fair market value of the owner's stock is determined through the services of a professional independent business appraiser.
Step Two: The company establishes an ESOP, which involves setting up a trust that will hold the stock to be purchased for the employees. Individuals or an institution appointed by the company will serve as trustee(s).
Step Three:The company borrows the purchase money from a bank or other commercial lender and then loans the proceeds to the ESOP. Alternatively, the ESOP trustees may be able to borrow the purchase money from a bank or other commercial lender directly, using the credit of the company as guarantor.
Step Four: The trustees present the owner with a check for the purchase price, and the owner transfers his stock to the ESOP trust. Then, as the ESOP loan is repaid by the company, the shares are allocated among individual accounts that have been set up within the trust for each employee.
To facilitate repayment of the debt incurred to purchase the stock, the corporation makes periodic cash contributions to the ESOP that are at least equal to the loan payments due to the lender. Within limits, these payments are generally tax deductible to the sponsoring corporation.
Federal law requires an ESOP to pay no more than fair market value for shares it acquires. The creation of an ESOP in a privately held company requires an independent appraisal at least annually to determine the fair market value of the stock and for all significant transactions involving the ESOP.
By making regular annual contributions to such a plan over a period of years, a company can build up a significant amount of employee ownership, generating a strong "ownership culture" in which employees feel a special commitment to the company. The plan can also serve as a component of the company's employee retirement savings program, reducing the cash flow that would otherwise be needed to fund a more conventional retirement plan.
ESOPs in S Corporations are exempt from federal (and some state) taxation. Since the tax liability of S Corporations is flowed through to individual shareholders on a pro-rata basis according to their ownership of the company, the total tax liability of the company is reduced by a percentage equal to the ESOP’s ownership. In many cases companies that are 100 percent owned by the ESOP are effectively tax-exempt entities.
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