How Do Employee Stock Ownership Plans (ESOPs) Work?

Retirement Plans
How Do Employee Stock Ownership Plans (ESOPs) Work?

A company can provide multiple benefits for its employees. Examples include vision and dental plans, retirement benefit plans, long-term care insurance plans and more. Employee stock ownership plans (ESOPs) are an exceptional benefit that companies may choose to provide.

ESOPs can motivate employees to grow and improve the business due to their direct connection with profitability. If the company is doing well and its stock is up, the employees gain value in their investments. In addition, ESOPs also offer retirement benefits for the employees by giving them partial ownership within the company.

What is an ESOP?

Essentially, an ESOP is a retirement plan provided by a company for its employees, set up as a trust fund. ESOPs are different from employee stock option plans. The stock option plans allow employees to purchase their company's stock at a set price after a given amount of time.

ESOPs provide employees with partial ownership of the company by increasing their stock holdings over time. Afterward, company stock can be sold for cash when the employee retires.

ESOPs benefit both employees, who gain partial ownership within the company, and its shareholders, which helps the company overall. In addition, they are commonly used to provide a market for any exiting owners.

Understanding ESOPs

Essentially, ESOPs are trust funds. A company can contribute shares or cash directly to the trust fund, or it can borrow money to purchase additional shares. All contributions are tax-deductible as employees do not pay any taxes on these contributions until they exit the company, giving them the option to either sell on the market or back to the company.

Benefits of Setting Up an ESOP

ESOPs are qualified plans providing tax benefits for both the company and its participants. The main reasons a company uses an ESOP plan are the following:

  • Aligns The Interests Between Employees and Shareholders. Employees have a more vested interest in the company's success because they have partial ownership. Because of this, they also want to drive up the value of the stock, which also benefits shareholders.
  • Facilitates Succession Planning. Business owners and founders often have a significant portion of their wealth in their companies' stock. With an ESOP, an employee leaving the company, including owners and founders, can sell their stocks without hurting the company's value. Shareholders that plan on selling often use an ESOP as an effective exit strategy. This strategy allows them to sell their portion of the business to an ESOP while keeping participants in the plan to work, which benefits the entire company.
  • ESOPs Provide Tax Benefits Like Other Qualified Retirement Plans. These are the three significant tax benefits offered to ESOPs:
    • Federal income tax - 100% ESOP-owned S corporations are not required to pay any federal income tax.
    • ax-advantaged leveraged buyout - Corporations can deduct the principal paid on an ESOP's loan to buy back the stock held by the ESOP.
    • Allowance of tax deferral - This option is only available for C corporations. It allows the owner's sale of the stock to the ESOP to be structured so it can be tax-deferred.
  • ESOPs Give Both Monetary And Non-Monetary Benefits To Employees. Owning shares in the company provides employees economic ownership of the company, which increases their appreciation of its value over time. Owning shares further incentivizes employees to work efficiently to drive up the company's value. It also helps employees understand how the company's performance links to its value. Lastly, giving workers ownership of the company also improves employee retention.

Using Your ESOP

ESOP participants get an annual statement showing them the number of shares allocated to them that year and their net account balance. The number of shares typically takes the employee's overall compensation into account.
Vesting provisions are also a vital element of an ESOP. There are two types, graded vesting and cliff vesting. Graded vesting is when a specified percentage is vested every year for a given period. Meanwhile, cliff vesting occurs when employees don't have any vested interest until they have been with the company for a specified period.
Benefit distribution methods can vary, and there are other options; however, the employee will receive equal installments of their stocks over five years. Participants will not receive the vested portion of their ESOP until either they retire, quit their job or die. Then the individual can sell the shares back to the company or sell them on the market.

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