From stock options to profit-sharing plans, there are many ways to provide employees with an ownership interest in a company. However, the most common method is a type of tax-favored employee benefit plan known as an ESOP, or employee stock ownership plan. Currently, over 6,400 ESOPs exist in the U.S., covering an estimated 14.2 million people. Commonly used by closely held businesses and some large, publicly traded corporations, ESOPs have become popular because they provide various tax benefits for companies, offer a way to motivate and reward employees, and create a market for buying out the shares of departing owners.
How do ESOPs work?
ESOPs are set up as trust funds to hold shares of the company’s stock on behalf of employees. Companies may fund an ESOP with newly issued shares, cash used to purchase existing shares, or by borrowing money through the trust to buy new or existing company shares. Contributions to the ESOP are tax deductible.
The shares of stock within the ESOP are then allocated to employees’ individual accounts depending on their relative pay or another formula that yields equal distribution. However, employees do not automatically own the shares—they must undergo a vesting period, meaning that they must work for the company for a certain amount of time before they are entitled to exercise their stock options. As they accumulate years of service to the company, employees become fully vested, which generally must happen within three to six years.
When vested employees retire or resign, the company buys their stock shares back from them at fair market value. The employee may receive the money from the purchase in either a lump sum or periodic payments, depending on the plan; the company then voids or redistributes the shares. Through this process, employees are able to gain an ownership interest in the company while they work there and a cash payout when they leave—which can serve as a significant retirement benefit if they have been with the company for several years—at no upfront cost to them. While employees are taxed when they are cashed out of the ESOP, methods such as rolling the amounts over into an IRA can help mitigate the tax consequences.
Benefits of ESOPs
In addition to the financial benefits for employees, ESOPs offer the following benefits for companies:
- They can motivate employees to perform optimally. Since ESOPs allow employees to become shareholders in the company, the idea is that they will be driven to work towards helping the company perform better, thereby yielding greater returns for themselves and other shareholders.
- They create a ready market for the stock of outside shareholders—including beneficiaries, the estates of deceased shareholders, and departing owners—of privately held companies.
- ESOPs serve as a unique corporate finance tool that allows companies to borrow money at a lower after-tax cost. Since contributions to the ESOP are tax deductible, companies can borrow money to buy shares of stock and repay the loan (both principal and interest) using tax-deductible ESOP contributions.
- They facilitate succession planning. ESOPs allow the owners of companies to cash out their shares over time while they gradually transfer control to a management team. This helps protect employees’ jobs and provide ownership continuity.
- ESOPs offer companies a variety of tax benefits. Contributions of stock and cash to the ESOP are tax deductible, as are some dividends. In addition, for C-corporations in which the ESOP owns 30% of all the company’s shares, sellers of shares can defer taxation on any gains. For S-corporations, the percentage of ownership held by the ESOP is not subject to federal income tax—so if an S-corporation is wholly owned by the ESOP, its profits will not be subject to income tax at the federal level and in many states.
Despite these compelling benefits, there are a few limitations and drawbacks to ESOPs. For example, they cannot be used in partnerships and most professional corporations. Additionally, the costs of setting them up and buying back the shares of departing employees can be substantial and must be weighed against the tax and other benefits. However, for many privately held companies, ESOPs can provide a powerful way to drive employee engagement, create a strong financial benefit for employees, and minimize taxation. To learn more about ESOPs and what they offer both company owners and employees, contact the Tax Diversification team today!
–Stephanie Vance, J.D.
We are Arbor Wealth Management, a Phoenix-based firm that offers comprehensive financial planning services. We’re partners in your financial future. Like a conductor coordinating a beautiful symphony, we’re intimately involved in your financial future. We take the time to know how each instrument in your personal orchestra is performing, keeping all aspects of your plan in tune. We accomplish this by making sure your finances remain pliable, whether you are in an accumulation or distribution stage in life.