Employee Stock Ownership Plans (ESOPs); What Are They?

Employee Stock Ownership Plans (ESOPs); What Are They?
By: Robert J.M. Scranton, J.D, M.T.
(719) 477-0333

Introduction

The ESOP is the most tax-advantaged mechanism for companies to share ownership with employees. An ESOP is an employee benefit plan operating through a trust that accepts tax-deductible contributions from the company to accumulate company stock, which is then allocated to accounts for individual participants. The ESOP can acquire both new and existing stock. The trust can borrow money to purchase the stock, with the company repaying the loan by making tax-deductible contributions to the ESOP.

Qualifying as an ESOP allows a company to receive valuable tax benefits. ESOPs are, however, complicated and expensive to set up, and for small companies, the tax benefits will not always compensate accordingly. ESOPs are a form of "qualified employee benefit plan," a structure governed by the same law as many other retirement and employee benefit plans, the Employee Retirement Income Security Act of 1974 (ERISA).

ESOPs can be used for a variety of purposes, such as:

· To buy the shares of an owner in a closely held company: The most common application for an ESOP is to use the company's pretax dollars to fund an ESOP (or to pay an ESOP loan) to buy shares from an existing owner. Once the ESOP owns 30% or more of the company's stock, any sales of stock to the plan can qualify the seller for a tax-deferred rollover of the gains when the sale-proceeds are reinvested in other stocks and bonds.

· To borrow money: An ESOP can borrow money to buy new or existing company shares, with the company repaying the loan in pretax dollars by making contributions to the ESOP. The loan proceeds can be used to buy a division from a parent, finance new capital, refinance existing debt, buy out an owner, or for any other business purpose.

· To create an employee benefit plan: Companies can simply contribute new shares of stock to an ESOP and take a tax deduction for them, or contribute cash that the ESOP can use to buy treasury shares.

Shares held in the ESOP trust are generally allocated at least to all full-time employees with a year or more of service, either on the basis of relative pay or some more level formula. When employees leave the company, they get their stock and can (if the company is closely held) sell it back to the company at an appraised fair market value.

Requirements

· Stock must be held in a trust. Each participating employee has an account in the trust. Stock is placed in an employee's account only during employment. The employee can receive dividends on the shares, but usually cannot sell the shares until leaving the company.

· Employees are usually prohibited from putting up money to purchase the stock. Generally, the company borrows or uses available funds to buy the shares from their current owners and contributes those shares to the trust, or contributes new shares.

· When employees leave the company they become direct owners of the vested shares in their accounts. The company must offer to repurchase the shares from the employee in cash. The company may retain the first right to buy the former employee's shares before the employee may offer the shares for sale to anyone else.

· Shares must be distributed in a "nondiscriminatory" manner. This means that most full-time employees must be included in the plan, and that the majority of the benefits cannot go to top managers, corporate officers, or highly paid employees. Allocation is by relative pay or some more equal formula.

· Shares in the ESOP usually must be voting shares, but the trust technically owns the shares, and the trustee has the responsibility to vote these shares in the interest of the trust's beneficiaries, the employees with accounts in the ESOP. However, voting rights must be "passed through" to employees in some cases. Employees must be able to vote on major issues such as whether or not to liquidate, sell, or merge the company. The law does not require, but does allow, employees to be able to vote for members of the board of directors and on other issues.

Tax Ramifications

· The company can borrow through the ESOP and deduct both principal and interest on loan payments.

· Generally, contributions to an ESOP are immediately deductible up to 25% of the company's annual payroll. Employees do not pay taxes until they actually receive their stock after they leave the company. (Compare to the tax treatment of direct ownership.)

· Persons who sell shares to an ESOP in a C corporation can defer capital gains taxes if they reinvest the money from the sale in qualified U.S. securities, and the ESOP owns 30% or more of the company's shares.

S Corporation Considerations

An ESOP can be an owner in an S corporation. Like any owner, an S Corporation receives an annual statement of the profits of the corporation attributable to its percentage of ownership, but, unlike these other owners, the corporation does not have to pay tax on this amount. This special tax benefit means that a 100% S corporation ESOP would pay no tax. Sellers to an ESOP in an S corporation, however, cannot defer capital gains taxes as they can in a C corporation ESOP and the deduction limits for S corporation ESOPs are lower.

When an S corporation pays its owners a cash distribution (usually so that they can pay their taxes on their share of the company's earnings), the ESOP must receive a pro-rata share of these distributions. Thus, if the ESOP owns 40% of the stock, it must receive 40% of the distributions.

Costs of Creating and Maintaining an ESOP

Because of complex and stringent regulations, ESOPs are more expensive to create and maintain that other forms of employee stock ownership arrangements. An ESOP company must have annual independent business valuations, which accounts for much of these costs. ESOPs also require the most specialized legal and financial services of structures discussed here.