An ESOP (employee stock ownership) Plan is a benefit plan for an employee that offers benefits to companies, business owner and their employees.
Companies create an employee trust fund and contribute money to buy shares in the company, contribute directly to the plan or make the plan loan money to obtain shares. If the plan borrows capital, the company makes contributions to the plan so that it can repay the loan. The contributions to the plan are deductible. Employees do not pay taxes on their savings until they receive shares when they retire or leave. They then either sell it to the market or return it to the company. Whenever an ESOP holds 30% or more of the company's shares and the company is a C corporation, the owners of a private company that sells to an ESOP may postpone income tax on their profits by reinvesting in the securities of other companies. Companies can also have ESOP. The profits attributable to the participation of the ESOP to the companies of the S corporation are not subject to taxation.
In other plans, around 800 employers partially correspond to the employee's 401 (k) contributions with employer quota contributions. Employees can also choose to invest in shares of the employer. In the option to buy shares and other individual stock plans, the companies grant employees the privilege to obtain shares at a fixed price for a certain number of years in the future. (Do not confuse equity options with US ESOPs) In India, an employee stock option plans are also referred to as "ESOPs," but U.S ESOPs has got nothing to do with stock options.)
The ESOPs are of two varieties: leveraged and un-leveraged. Each of the ESOP has different characteristics.
Funco Inc. establishes an ESOP and pays annual cash contributions, which are used to purchase shares of the company's shares or to pay annual contributions to the shares. These contributions are deductible for the company. Since shares are allocated to participants' accounts based on a value determined by an independent valuation, employees begin to acquire a stake in the business.
The employee/participant begin to invest according to a program embedded in the ESOP document, and the stock is accumulated in the account until the employee/participant leaves the company or withdraws. At that time, the employee owns the right to receive shares of a value equivalent to his interests. Generally, ESOP documents contain a clause called "sale," which requires the Plan or the company to purchase employee shares after distribution if there is no public market for them, which increases the liquidity of the shares.
Non-leveraged ESOPs, while having some tax advantages in general, tend to be a benefit to employees, a vehicle for creating new shares or a way for the management to acquire existing stocks.
Leveraged ESOPs tend to be more complex than the non-leveraged ESOPs. Nevertheless, they provide the company with tax advantages through which it can generate capital or acquire shares in circulation. A leveraged ESOP is also used to inject funds into the company through the acquisition of newly issued shares.
FunCo establishes an ESOP. A bank or another credit institution lends money to ESOP that acquires shares in the company. The company pays annual contributions deductible to the ESOP, which in turn repays the loan. The action is attributed to the accounts of the participants, for example in a non-leveraged ESOP, which allows employees to collect shares or money when they retire or withdraw from the company.
The advantages of an ESOP are numerous and varied, depending on whether you are an employee/participant, an existing shareholder or an employer.
An ESOP can provide an employee with considerable retirement assets if the company hires the employee for a major period and the employer's shares have been appreciated over the years until retirement. Usually, the ESOP is designed to help employees who stay with the employer for a more extended period and contribute more to the success of the employer. Because the actions are assigned to each employee's account based on a company contribution, the employee assumes no cost for that benefit.
Employees do not pay taxes on the amounts paid by the employer to the ESOP or the income earned on that account until they receive the distributions. Even so, "transfers" to an IRA or particular methods of calculating income can reduce or defer the consequences of the distribution of income tax.
When the employee's participation in ESOP ends, he is entitled to his share of the "granted" benefit under a program incorporated in the ESOP document. Distributions can be made in stock or cash. However, a "sale" option, which requires the Plan or the company to acquire shares distributed to participants, can provide money for its shares. This is particularly useful for participants in private companies, where there is no market for company shares.
An ESOP can birth a market for the actions of a private company. ESOP offers a current market and is ready for the actions of external shareholders providing liquidity that is not otherwise available. This function can be used by participants, beneficiaries, major shareholders or deceased shareholder states.
The ESOP leverage provides a way for a selling shareholder to receive money instead of incurring the risk of a deferred payment arrangement.
Subject to certain conditions and regulations, the Code provides special tax incentives for certain sales of shares to an ESOP. This would allow a shareholder of a limited liability company to sell shares to an ESOP, reinvest income in other qualified securities and postpone taxes on any profits from the sale.
An ESOP is expected by law to invest contributions primarily in the actions of the employer. It is also the only benefit plan for skilled employees who are authorized to borrow from the employer to buy shares from the employer. These differences offer significant flexibility for a company that uses an ESOP as a business finance tool and enables it to achieve business goals that are not available by other methods.
As a business finance technique, ESOP can be used to collect new shares to refinance outstanding debts or to acquire assets or outstanding shares through leverage with third-party creditors. Since contributions to an ESOP are entirely tax deductible, an employer can finance principal and interest payments on ESOP debt servicing obligations with pre-tax dollars. Dividends used to repay a loan can also be deductible.
Another vital advantage for the employer and shareholder is the positive impact that occurs when employees have an interest in the company. This translates into higher productivity, profitability and overall business performance.
An ESOP is a compelling tool for employee benefits and corporate financing; its structure can vary from simple to very complex. Its profitability should be taken into account by lawyers, accountants, and competent administrators to ensure compliance with the IRS regulations and to comply with the requirements of the benefit plan of the Department of Labor.
Debi G Hill, CPA