ESOP – employee stock ownership plan, is a qualified employee benefit plan which provides employees of a business an ownership interest in the business. ESOP’s are used by employers to reward employees, or as an exit strategy from business ownership. If owned by an ESOP, the business can potentially get a lot of great tax benefits.
Let’s talk about how an ESOP works first
An ESOP is employee benefit plan which is established by the owners of a company. When you use an ESOP, the plan essentially either borrows funds, or gets contributions from the company. These funds are then used to purchase shares in the business. It’s a great way for business owners to transfer full or partial ownership of the company to employees and get a number of tax benefits.
When a business owner establishes an ESOP as a retirement benefit for their employees, they create a plan which outlines the structure, and the policies. In addition, they appoint a trustee, or a committee, which then oversees the plan. It’s typical for one of the company employees to be appointed in order to represent the employees.
Every ESOP plan document has limits. For example, business owners can transfer full/partial ownership of the company to employees with either voting or nonvoting shares. Using this type of structure, business owners can keep control of the company until the ESOP buy all of the shares.
ESOP Benefits For Employees
ESOP’s are a great perk for eligible employees. ESOP eligibility is typically outlined in the plan. The maximum age an employer can impose to be eligible for an ESOP is 21. The employees must be eligible for the ESOP within 1 year of joining the company. Employers can restrict the eligibility to employees with two years of service, but only if the plan has an immediate vesting schedule. One of the biggest ESOP benefits for employees is that an ESOP gives employees the ability to get shares in the business without contributing any of their own money. Instead, a company will make contributions every year which are used to buy shares, or repay a loan, which was used to buy shares.
The main reason employers consider ESOP’s is the fact it’s a business transition tool. In the absence of an ESOP – an employer has only two options: sell the business, or gradually take money out of the company and shut it down. By using an ESOP, the company can continue and the owner can play any role they want going forward. The owner of the company is able to defer taxes, and reinvest the gains in other securities.
With an ESOP, owner’s don’t have to sell everything at once. They can sell out some now, and some later. Or, one owner can sell, and another can hold. ESOP’s only work for companies that have enough in profit to purchase shares + still run the business. They are not worth doing in companies with 20 or less employees due to the cost and complexities involved.
Types of ESOPs
There are three types of ESOPs most employers use to transfer full/partial ownership of a company to the employees. The plan document governs the plans including the type of ESOP it is.
Three primary types of ESOPs are:
Unleveraged ESOPs: These are the most basic type of ESOP. When you use an unleveraged ESOP, a company is making periodic contributions to the plan, which is then used to buy shares in the company from current owners. Unleveraged ESOP is ideal for a business owner who wants to be bought out over time. It’s a great plan and great way to reward an employee who stays with the company over an extended period of time, instead of the employees who are with the company at a singular point in time.
Leveraged ESOP: In this type of plan, the plan takes out one or more loans from a bank or other lenders. The borrowed funds are then used to buy shares in the company from the owners of the company. The company makes regular contributions to the ESOP which are used to repay the loan taken out. Leveraged ESOP’s are very common, and are a better option for business owners who really want to be bought out quickly. When you use a leveraged ESOP, the business owners can structure a loan for the ESOP to buy a large number of shares in the company all at once – rather than in little pieces over time.
These are the least common types of ESOPs. Companies who are using an issuance ESOP make regular contributions to the plan which is comprised of newly issued shares of company stock instead of cash. An issuance ESOP is a fantastic choice for business owners who don’t want to contribute profits to the plan but instead want to issue new shares to the plan. Using the structure, current owners of the business have the ownership shares diluted over time as the number of outstanding stock shares increases.
ESOP Benefits for Business Owners
ESOPs are a great benefit business owners don’t want to to focus on finding a buyer for their business. Business owners can use an ESOP to create a buyer for their company right right from their employees. ESOPs are great to help attract employees and it helps reward long-time employees for their dedication and service.
ESOPs are useful for a number of situations like:
Attracting talent: When you have an ESOP it’s great because you can hire more attractive talent without having to pay extra money. This is great for recruiting!
Reward employees: If you have employees that have been with you for years, then an ESOP is a great way to reward them for their years of dedication and service.
Transfer control of a business: ESOPs are a great way to allow business owners to create a potential buyer for the company via their employees.
Low-cost to employees: Employees don’t have to participate in an ESOP unlike a 401k. Businesses cover the costs of an ESOP and make the contributions to buy company stock from the existing business owners.
When you use an ESOP, business owners can make contributions to the plan each year which are tax-deductible – up to 25% of the company’s payroll. Business owners can also have the ESOP borrow money in order to buy shares in the business. It’s a win-win scenario!
One of the biggest benefits of an ESOP for small business owner is the tax benefits. If you are a C-corp, then any profits paid to the ESOP as dividends are tax-deductible. Once an ESOP owns 100% of the business, then the business is exempt from corporate income taxes.
When shouldn’t you use an ESOP
ESOPs are a great benefit for small businesses, but aren’t ideal. ESOPs don’t work for very large companies that cost too much to buy, or super small businesses with just a few employees, or with businesses that have trouble retaining employees. Here are some instances where ESOPs aren’t a great idea.
Large companies: Very large, or publicly traded companies are often too valuable for an ESOP to purchase over time.
Very small companies: Super small companies with low revenue or few employees often aren’t worth the cost of setting up an ESOP.
Multigenerational businesses: If you have a company which has been family-controlled for many generations, you might want to make sure that the stock ownership and voting rights stay in the family.
Retirement asset businesses: If you depend on the sale of your business in order to finance your retirement – then an ESOP isn’t a good idea – because it uses company profits in order to finance the buyout.
One of the biggest reasons companies elect for an ESOP is the tax treatment you get. When you use an ESOP, businesses can make contributions to the plan which are tax-deductible for the employer. It allows business owners to reward employees while reducing the tax burden.
How ESOP vesting schedules works
Employers that offer ESOPs choose the schedule for vesting shares that employees own through an ESOP. Vesting schedules for an ESOP are outlined in the plan document, and if you leave the company before you are fully bested – then you forfeit some of the stock. The IRS usually requires that employees be fully vested – after 6 years – depending on the type of vesting schedule setup. Under Section 411 of the internal revenue code, employers who use ESOP vesting can choose from 2 different types of vesting schedules. Under graded vesting, employees are vested in event amounts over many years, but must be fully vested in 6 years. Employees with a cliff vesting schedule have to vest all at once, within 3 years.
ESOP Vesting Minimum Requirements
|Cliff Vesting||Graded Vesting|
Employees whose plans are dictated by ESOP vesting schedules can vest faster than the minimum requirements – but cannot vest slower. Vesting doesn’t occur for each year individually, but all at once. If an employee covered by a cliff vesting
Employees whose plans are subject to an ESOP schedule can vest faster than the minimum requirement but can’t vest slower.
ESOP Immediate Vesting
There are some minimum vesting requirements that businesses have to meet in order to use an ESOP. Business owners can have faster vesting schedule in their plan document. Some ESOPs immediately vest stock owned by an employee via an ESOP. The shares in the ESOP – however can be sold at any time or kept if an employee leaves the plan.
ESOP Tax Benefits
ESOP taxes for employees are usually really low. Employees don’t pay any taxes on employer contributions to the ESOP. There’s no tax implications due to the fact the employees accumulate ownership through the ESOP. The only taxes the employees pain in an ESOP are on the profit distributions. The individual IRA eligible participants can sometimes roll the distributions into an IRA in order to grow tax free.
Employee ESOP Tax Considerations To Think About
No taxes on employer contributions: Employer contributions of either cash, or stock, or tax-deductible to the employer up to 25% of the total payroll. Contributions also aren’t taxable to employees.
No taxes on contributions to repay ESOP loans: If your ESOP has to borrow money in order to buy shares in the business, then the contributions used to repay the loan aren’t taxable for employees. The contributions are also tax-deductible for employers.
No taxes on ownership % that accumulates: As employees build ownership in the business via an ESOP – there are no taxes on this increased % ownership.
Taxes on profit distributed: Employee distributions from an ESOP are taxable but can be taxes as capital gains instead of income or rolled into an IRA with all of the taxes now being deferred.
ESOP distributions are subject to SOME of the rules as IRA distributions. It means that in addition to the income, or the capital gains taxes on ESOP distributions, the employees are also subject to a 10% penalty if they take distributions too soon.
ESOP Tax Benefits for Small Business Owners
ESOPs offer a lot of tax benefits to small business owners. When you use an ESOP, employers can contribute either cash or stock which is tax-deductible for the business. The biggest tax benefit of an ESOP is that if a business is owned completely by an ESOP – then it’s also exempt from corporate income taxes. In addition to tax-deductible ESOP contributions, business owners can also get other tax benefits by selling their stock to an ESOP. For example, business owners can defer capital gains from the sale of stock to an ESOP – once the ESOP owns more than 30% of the business. In order to o this, company business owners have to reinvest any money they earn when the ESOP ends up purchasing their shares.
ESOP Rules and Regulations
If a business owner offers an ESOP, there are rules which have to be followed in order to make sure the ESOP isn’t disqualified. When you structure an ESOP, business owners have to offer a vesting schedule which meets certain standards. Business owners also have to enroll employees who become eligible for the plan. If you have an ESOP through work, you should make sure the business owner is following the rules of the ESOP plan carefully. If the owner fails to follow the rules, it can cause your plan to be disqualified, or the employer to incur penalties!
ESOP Rules For Business Owners
In order to use an ESOP, employees have to make sure that their employers are following the rules. For examples, business owners have to enroll all of their eligible employees. The owners contributions to the ESOP are limited based on the company revenue. Contributions are usually capped at 30% of earnings before EBITDA. Here are some important ESOP rules you have to follow:
- ESOP contribution limits are capped at 30% EBITDA
- All eligible employees must be enrolled
- You have to follow vesting guidelines
- You have to pay ESOP taxes where applicable
- Employees must have a trustee appointed to represent the interests of the employees
- Meet ESOP vesting schedule – employers can either use a cliff or graded vesting schedule. Employees have to be vested no longer than a 3 year cliff, or 6 year graded vesting period
If you work for a company which offers an ESOP, then it’s important your employer follow the rules of an ESOP. If your employer violates the rules, then the plan can run into penalties or other tax liabilities.
ESOP Plan Costs
ESOPs can be very expensive to setup. One of the biggest advantages of an ESOP for employees is they pay almost none of the cost. The biggest cost employees incur from an ESOP is that their stock ownership plan can take the place of cash bonuses or profit sharing. Businesses pay the costs of record keeping, financial advisors, etc, who structure the transaction and the costs of the contributions. The costs must be paid before either company the company owners or the ESOP get profit distributions from the company. Below are some costs of an ESOP plan.
Setup Costs: ~ $75,000
Business owners have to pay legal fees and appraisal costs to setup an ESOP. These fees drastically increases the first year costs of the plan.
On-going Administration: $20,000 annually
Maintaining an ESOP requires an annual review, as well as representation by a trustee whose job is to protect the participants of the plan.
Recordkeeping: $2000 to $6000 plus a fee per employee
In order for the ESOP to be valid, you have to keep detailed records of the contributions to the plan as well as stock as stock purchases, and the vesting schedule of each employee.
Contributions: Discretionary for employer
Most employers setup an ESOP and provide regular contributions each year for a period of time. ESOP contributions are decided by the employer.
ESOP contributions are tax-deductible up to 25% of the total payroll. The ESOP contributions aren’t taxable to employees. Employee distributions though, are taxable, but those taxes can be deferred if the employees roll the distributions into an IRA.
Financial Advisor Fees: 1-3% of the transaction size
This is an optional cost. Many employers have financial advisors in order to setup the ESOP buyout. While employees don’t pay the costs directly, it’s important to be aware of them and how the costs work.
ESOP vs ESPP
In an employe stock purchase plan, employees contribute to the plan with salary deductions. It’s like a 401k. The contributions are used to purchase stocks in the company at a discount. Unlike an ESPP, ESOP’s don’t have employee contributions. Instead, employers make tax-deductible contributions in order to buy company owners’ stock for the plan. Employees don’t usually get a choice between an ESOP or ESPP. Instead, an employer chooses one and sets it up for the employees. Employers who choose an ESPP – should be willing to accept lower plan participation since ESPPs require contributions from employees or be willing to sell only a part of the company. When you use an ESOP, company owners have to contribute the money for the employees to buy their companies. They can also control the pace and structure of the companies prospective sale.
Pro’s and Con’s of an ESOP
ESOPs are a great asset to employees. Employees can build an ownership stake in the business with no real personal costs. The costs are entirely on the business itself. Business owners get to make tax-deductible contributions, and can use an ESOP to attract talented employees.
Pro’s of an ESOP
For an employee the ESOP is a great tool. Employees can get free shares in a company which they can sell at a later time. Costs are high, but the business handles all of them. Employees can also eventually take over operations and running of the company when the buyout is complete. ESOPs are great for recruiting, and the biggest reason business owners love an ESOP is the tax benefits.
Some ESOP benefits include no taxes for employees – which means there are no taxes on the ESOP plan contributions, only on the distributions which can be deferred if you roll them into an IRA. There’s also no cost to employees! Employees pay virtually none of the costs of an ESOP – unlike a 401k – where some of the contributions are used to cover the plans administration costs. In addition, an ESOP has a built-in buyout – where employees who have access to an ESOP plan don’t have to wonder if they can buy the business. When you have an ESOP – it’s all setup inherently.
Cons of an ESOP
There are literally no ESOP drawbacks for employees. ESOP can take the place of a cash bonus, or profit sharing. The biggest drawback of an ESOP is the high cost to employers.
Here are some cons of an ESOP: employees may not have control even though the employees will be invested in the business through the stock plan. The plan, if setup correctly, doesn’t need to grant rights or decision making power to the employees. It makes it difficult or impossible for employees to protect their investment into the company. In addition business owners have to make sure the business is run in a way which benefits the plan. Owners of businesses have a fiduciary duty to the shareholders/employees of the plan – which means they have to run the company for the plan’s benefit and can’t take excess compensation.
How to setup an ESOP plan
Setting up an ESOP doesn’t require any input from employees. Employers decide whether to setup an ESOP, and employees can decide whether they want to participate. If your employer offers an ESOP, it’s up to you to familiarize yourself with enrollment qualifications and make sure you’re able to enroll when you’re eligible. Below are the four steps business owners have to go through in order to setup an ESOP:
- Choose an ESOP Provider – Setting up an ESOP requires hiring an attorney and appointing a trustee to represent the employees in the plan. While some business owners can setup an ESOP using their attorney and their financial advisor, it can be a good idea to use a company that specializes in just ESOPs.
- Draft / Adopt an ESOP Document – Once you choose a provider, the business must work with their attorney / ESOP provider to prepare an ESOP document. The ESOP plan documents outline everything about the plan, including eligibility criteria, etc. It must also designate a trustee to represent employees in the plan.
- Enroll ESOP Eligible Employees – After an ESOP plan document is drafted, and adopted, employers have to enroll all employees who are eligible to participate in the ESOP. Qualifications for the plan are in the ESOP plan document. Employers have to be careful not to exclude employees who are eligible for the plan.
- Make Cash or Stock ESOP Contributions – When the plan document has been formed, and employees have been enrolled, the last thing left is to administer the ESOP. This can be done by having the ESOP borrow money in order to purchase stock in the company and then making tax-deductible contributions which can be used to repay the loan. Employers can contribute stock directly into the ESOP, or contribute cash, which can then be used to purchase the shares.
If you choose to use a leveraged ESOP, the steps are basically the same except for the administration of a plan. Under a typical unleveraged ESOP, a company can make contributions which are used to purchase stock shares of the company over time. In a leveraged ESOP, the process is reversed. The plan borrows money, which are then used to buy shares of the company. The company makes contributions over time in order to repay the loan.
ESOP Frequently Asked Questions
An ESOP is different from a 401k. In a 401k, the employees contribute through salary deductions which they invest into stocks and bonds etc. They also get employer matching, and profit sharing contributions. An ESOP is like a 401k plan, but it gradually shifts ownership from the companies owners to its employees.
ESOP distribution is a withdrawal that employees take from the ESOP account after they vest. ESOP distributions are taxed as ordinary income, but can be taxed as capitals gains in some instances. ESOP distributions can also be deferred if the employee rolls the distributions into an IRA.
ESOP vesting periods are timeframe where an employee must wait until the stock in their company is vested. ESOP vesting is similar to a 401k vesting schedule. It’s part of the plan.
Leveraged ESOP is an ESOP plan which takes out a loan in order to purchase company stock from the owners of the business. With a leveraged ESOP, employer contributions are used to repay the ESOP loan over a long period of time.