Is an ESOP the Right Choice for Your Company?
Employee stock ownership plans have been in the headlines recently, but they have been around for decades. ESOPs are qualified defined contribution plans in the form of stock bonus plans or stock purchase/money purchase plans. They are governed by Internal Revenue Code Section 401(a) and the Employee Retirement Income Security Act, also known as ERISA.
What's put ESOPs in the news again? The difficulties associated with attracting and retaining talent, the influx of private equity into professional services and other businesses, and business succession issues are among the reasons for renewed interest in ESOPs. Employees — and prospective employees — often find it very attractive to have a financial stake in the business's success, especially if they have an eye on creating a secure retirement.
Common ESOP FAQs
Below are the answers to some common questions about ESOPs.
Can all companies offer an ESOP?
No. The company must be structured as a C corporation or an S corporation and the shareholders must agree to sell their shares.
How big does my company have to be to offer an ESOP?
Surprisingly, size is not the main consideration; profitability is. In addition, companies have to be willing to enter a long-term financial commitment.
How are ESOPs funded?
ESOPs are funded with company stock that is held in a trust fund set up by the company. The shares in the trust fund can come from existing company shares, newly issued shares or shares purchased with borrowed money.
How is the trust fund managed?
The trust fund is managed by a designated trustee who acts as the plan's fiduciary. A fiduciary is legally and ethically responsible for managing the trust for the benefit of the ESOP trust's owners. As part of this duty, the fiduciary is responsible for ensuring that all participants have voting rights and are subject to the same rules.
Who can participate in an ESOP?
Plans differ, but in general employees who are age 21 and older and have completed one full year of service can participate.
How are shares earned?
In a contributory ESOP, management sets a percentage of payroll compensation, which must be the same for all eligible participants. If, for example, the percentage is 8% of salary, everyone from the CEO to the cleaning crew receives a share equivalent to 8% of their compensation. The dollar amounts differ from employee to employee, but the percentage does not. It is important to note that there are annual contribution limits, and special rules apply for disqualified or highly compensated employees.
Are all ESOPs structured the same way?
No. An ESOP generally owns between 50% and 100% of the company's shares. If the ESOP owns 100%, the company is fully owned by its employees. If the ESOP owns less than 50%, the ESOP is a minority shareholder and control of the company effectively remains with the original shareholders or owners.
How does vesting work?
Distributions from the plan are generally tied to a process called vesting. An employee may be vested immediately, after a certain amount of time (e.g., five years) or gradually over time (e.g., 20% after year one, 40% after year two, 60% after year three, 80% after year four and 100% after year five). When a vested employee leaves, the company buys back their shares and gives the employee the shares' cash value. But there is a caveat: Being vested does not necessarily mean the ESOP shareholder can cash out. To cash out, the employee needs to have experienced a life event, such as retirement, termination, disability or death. Age is an additional factor. For example, if the person is below age 59 1/2, making a withdrawal may subject them to a 10% penalty.
What are the tax benefits of an ESOP?
The taxation of ESOPs can be complicated. However, employers can generally deduct contributions to the ESOP and defer taxes on their ESOP benefits until they receive their vested amount.
Transparency is a key ingredient to making an ESOP successful. When considering forming an ESOP, company leaders must keep everyone apprised of important company matters. This transparency must continue as time progresses. Employees who feel invested both financially and informationally may feel more commitment to, engagement with and loyalty for the company.
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To find out whether an ESOP is a good fit for your business, consult with us and legal professionals who can help you navigate the specifics.