What does ESOP stand for?
An employee stock ownership plan is a qualified defined-contribution employee benefit plan designed to invest primarily in the sponsoring employer’s stock. ESOPs are qualified in the sense that the ESOP’s sponsoring company, the selling shareholder and participants receive various tax benefits. Companies often use ESOPs as a corporate-finance strategy and to align the interests of their employees with those of their shareholders.
As a tax-qualified retirement plan meeting, the requirements of state and federal tax law and regulations, an ESOP gives employee participants an ownership interest in their employer. An ESOP is a type of stock bonus plan; a defined contribution retirement plan that is designed to be funded with employer stock.
Since ESOP shares are part of employees’ remuneration for work provided for the company, companies can use ESOPs to keep plan participants focused on corporate performance and share price appreciation. By giving plan participants interest in seeing the company’s stock performing well, these plans encourage participants to do what’s best for shareholders, since the participants themselves are shareholders. Companies provide employees with such ownership often with no upfront costs. The company may hold the provided shares in trust for safety and growth until the employee retires or resigns from the company. Companies typically tie distributions from the plan to vesting – the proportion of shares earned for each year of service – and when an employee leaves the company.
After becoming fully vested the company “purchases” the vested shares from the retiring or resigning employee. The money from the purchase goes to the employee in a lump sum or equal periodic payments, depending on the plan. Once the company purchases the shares and pays the employee, the company redistributes or voids the stocks. Employees who resign or retire cannot take the shares of stock with them, only the cash payment. Fired employees often only qualify for the amount they have vested in the plan.
How does an Employee Stock Ownership Plan (ESOP) Work?
ESOPs provide a variety of significant Tax Benefits for Employee-Owned Companies and their Owners. Employee ownership plan can be accomplished in a variety of ways. Employees can buy stock directly, be given it as a bonus, can receive stock options, or obtain stock through a profit-sharing plan. Some employees become owners through worker cooperatives where everyone has an equal vote. But by far the most common form of employee ownership in the U.S. is the ESOP, or employee stock ownership plan. Almost unknown until 1974, ESOPs are now widespread; as of the most recent data, 6,669 plans exist, covering 14.4 million people.
Companies can use ESOPs for a variety of purposes. Contrary to the impression one can get from media accounts, ESOPs are almost never used to save troubled companies—only at most a handful of such plans are set up each year. Instead, ESOPs are most commonly used to provide a market for the shares of departing owners of successful closely held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring new assets in pretax dollars. In almost every case, ESOPs are a contribution to the employee, not an employee purchase.
Uses for Employee Stock Ownership Plan
1- To buy the shares of a Departing Owner
Owners of privately held companies can use an ESOP to create a ready market for their shares. Under this approach, the company can make tax-deductible cash contributions to the ESOP to buy out an owner’s shares, or it can have the ESOP borrow money to buy the shares.
2- To borrow money at a Lower Tax Cost
ESOPs are unique among benefit plans in their ability to borrow money. The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible.
3- To create an additional Employee benefit
A company can simply issue new or treasury shares to an ESOP, deducting their value (for up to 25% of covered pay) from taxable income. Or a company can contribute cash, buying shares from existing public or private owners. In public companies, which account for about 5% of the plans and about 40% of the plan participants, ESOPs are often used in conjunction with employee savings plans. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level.