ESOP: What is it?
An Employee Stock Ownership Plan (ESOP) is a type of employee benefit plan, similar to a profit sharing plan, that is designed to invest primarily in the stock of the employer. ESOPs can be used by private or public companies in a variety of ways: as a vehicle for retirement for employees, a tax-advantaged method to raise new capital, an exit strategy to give owners an avenue to sell their shares, to create a subsidiary of the employer, or as an incentive to increase employee morale by sharing ownership of the company with its employees. ESOPs can own any percentage of the employer, including owning up to 100% of all the employer stock. Because the ESOP is often used as a financing tool for the employer, and because the qualified retirement plan is the shareholder for the employer, there are features unique to ESOPs that are not available for other qualified retirement plans.
Unlike a 401(k) plan, the ESOP typically consists solely of contributions from the employer rather than contributions from the employee, and an ESOP is specifically allowed to finance the purchase of employer stock. To contribute to the ESOP, the employer makes tax-deductible contributions in cash to repay a loan that was used to purchase shares, or the cash is used to purchase shares directly from the employer or owners without the use of a loan. The employer may also make tax-deductible contributions to the ESOP in the form of employer shares rather than cash, but this likely dilutes the value of the existing shares and is not the preferred method of contribution to an ESOP. Once the ESOP obtains additional shares of the employer, the employees then receive the employer shares in their ESOP account based on a formula that takes into consideration the employee’s compensation and years of service with the employer. All employees are eligible to participate in the ESOP after a certain period.
The employee’s stock in the ESOP is generally subject to a vesting period. Once vested, the employee receives his or her vested stock from the ESOP upon a termination of employment, retirement, death, or disability. When the employee receives a distribution of stock from the ESOP, the employer is then required to buy back the stock at its fair market value. The repurchase may occur in a lump sum or over a period of years.
ESOPs serve a variety of purposes other than providing a retirement benefit to employees. An ESOP may provide a market for the shares of a departing owner of a successful closely held employer, providing a motivation for employees to become a partial owner of the employer, and it may allow the employer to take advantages of tax incentives available only to ESOPs.
Several tax incentives are available only to plan sponsors of ESOPs or to the owners selling shares to an ESOPs:
- Contributions of stock to the ESOP are tax deductible;
- Cash contributions to the ESOP are tax deductible;
- Contributions used for both the principal and the interest to repay a loan the ESOP takes out to buy employer shares are tax deductible;
- In a S-Corporation, the percentage of ownership held by the ESOP is not subject to income tax;
- Owners of a C-corporation who sell stock to an ESOP can defer tax on the gain; and
- Dividends paid on the shares associated with the ESOP are tax deductible
Although S-corporations may sponsor an ESOP, there are some special considerations for S-corporations, including a prohibition of allocations to certain disqualified persons, dividends paid on employer securities, the rollover of stock from the S-corporation that is distributed from the ESOP, and other issues only applicable to ESOPs.
Leah Singleton Brings ESOP Experience to Hall Benefits Law
This month’s HR Alert comes compliments of Leah Singleton, HBL’s Director of Legal Operations, and it is the first in a series of HR Alerts covering Employee Stock Ownership Plans (ESOPs). Leah has extensive experience with ESOPs and benefits in mergers and acquisitions, significantly expanding Hall Benefits Law’s capabilities in both of these practice areas.
Leah will be sharing her extensive knowledge of ESOPs at this year’s Fall ESOP Forum this October 3-4 in Tampa, Florida. READ MORE ABOUT THIS EVENT.
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