Employee Stock Ownership Plan (“ESOP”)
Employee-owned corporations are corporations owned in whole or in part by their employees. Employees are usually given a share of the corporation after a certain length of employment or they can buy shares at any time. A corporation owned entirely by its employees will not have its shares sold on public stock markets. Employee-owned corporations often adopt profit sharing where the profits of the corporation are shared with the employees. They also often have boards of directors elected directly by the employees.
Employee ownership appears to increase production and profitability, and improve employees' dedication and sense of ownership.
An Employee Stock Ownership Plan (“ESOP”) is a type of defined contribution benefit plan in the U.S. that buys and holds company stock. ESOPs are often used in to buy part or all of the shares of the existing owners, providing a tax-deductible market for the acquisition of shares of company stock from existing shareholders.
An ESOP is a tax-exempt entity (technically, a trust) for federal and state corporate income tax purposes, enabling a company to make cash and company stock contributions to the trust. Contributions are then used to acquire stock of the company on behalf of its employees. The company can retain a certain amount of control because its Board of Directors appoints the Trustee.
What are the Benefits of Establishing an ESOP?
ESOPs offer many benefits. To a private company shareholder, an ESOP is a buyer of stock. To an employee, it is a company-funded retirement plan, and to the company it is a corporate finance technique. An ESOP can be used to:
- Provide a private company’s shareholders with a diversification vehicle to avoid having the overwhelming majority of their net worth invested in company stock.
- Provide a tax-deductible and flexible in-house market for the acquisition of shares of company stock from existing shareholders.
- Provide a funded plan for the succession and transition of the business.
- Decrease the company’s income tax liability, thereby enhancing its cash flow for continued growth and debt reduction.
- Provide a means whereby the employees of the company will be able to acquire a beneficial interest in the company so that the employees will have a direct interest in the success of the business.
- Borrow money for the stock purchase and repay the entire loan with pre-tax dollars.
- Attract, retain, motivate and reward productive employees.
What Kind of Company is a Good ESOP Candidate?
The following are some common traits of companies who choose to implement ESOPs.
- Private companies that have major or minor stockholders who wish to cash out, either immediately or over a period of time.
- A company in which stockholders are of different ages with different exit time frames.
- A company in which stockholders want to diversify their net worth by selling part of the company, but not necessarily relinquish control of the business.
- A company that wishes to increase working capital and cash flow.
- A company owner who wants to make way for successor management, such as working heirs or other key executives.
- A company that has major stockholders who wish to indefinitely defer payment of the capital gains taxes on the sale of company stock.
- A company owner who wishes to transfer ownership to employees (tax free) in lieu of other benefits.
Other Items to Consider
In order to successfully implement an ESOP stock transaction, a company should be profitable, with at least 15 full-time employees. If you meet these criteria, especially if you already maintain a profit sharing plan or a 401(k) plan, you should definitely consider establishing an ESOP. By establishing an ESOP, you can create a tax-deductible, in-house market to give you liquidity for your own stock if and when you choose to sell some shares. Under certain conditions, you can even sell tax free.
Employee ownership does not necessarily lead to a loss of control. Regardless of how much stock the ESOP acquires, you will still indirectly be able manage your company. The Board of Directors of a company appoints a trustee to vote the stock in the plan. Thus, control can continue as it is currently, or change as the Board sees fit. The employees do not directly own the company stock - employees are beneficiaries of the economic value of the trust's investments; the ESOP trust owns the stock.
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