What are ESOPs?
Written by True Tamplin, BSc, CEPF®
Updated on July 10, 2021
An Employee Stock Ownership Plan (ESOP) is a retirement plan to provide stock ownership of a company to its employees at discounted prices. ESOPs provide tax benefits to employers and are used as incentives to retain employees. The drawbacks to ESOPs are high administration costs and losses, if the company’s share price tanks.
Basics of ESOPs
ESOPs must not be confused with Employee Stock Options, which provide employees with the right, but not the obligation, to purchase company shares at a discounted price in the future. On the other hand, ESOPs provide employees with company shares with an attached vesting schedule. Ownership of the shares is transferred to the employee over a number of years.
A series of tax reforms starting in 1974 paved the way for ESOPs to become popular. These reforms provided tax breaks and were meant to encourage companies to set up ESOP programs for their employees. In the last four decades, ESOPs have become popular with companies as a means to retain employees and providing them with skin in the game for company success. Companies often run multiple ESOP programs in their organizations based on different criteria, such as pay grades and years of service.
According to 2018 data from the National Center for Employee Ownership (NCEO), there were 6,501 ESOPs in the United States and they held total assets of $1.4 trillion. 6,272 companies, a vast majority of them privately-held, had enrolled 14 million participants in such plans.
How do ESOPs Work?
ESOP operations are conducted through a trust set up and funded by the company. The trust contains company shares or cash to purchase shares. The company’s contributions to the trust offer tax benefits because they are made pretax, meaning the company offering ESOPs can deduct it from their overall tax bill. Per existing regulations, the amount of those deductions can change based on depreciation and amortization costs and regulations.
The trust allocates shares to employee accounts in the trust. The shares are not immediately available to employees; ownership is transferred over a period of time. The shares represent an ownership share in the company and provide employees with the right to vote on important issues and matters relating to the organization. When an employee quits or retires, they sell the shares back to the company at market price. Privately-held companies must conduct an annual and independent appraisal of their stock’s value.
Mary is the chief executive officer at a car manufacturing firm. Part of her salary is paid through an ESOP program. She gets an annual base salary of $1 million and the rest of it is tied to ESOP incentives tied to time and performance.
She gets 10,000 restricted stock units (RSUs) of the company’s shares, if she stays with the company for a minimum of three years. She will get another 10,000 RSUs if she guides the company to profits in excess of $1 million. The number of RSUs awarded to her increases with time and performance. For example, if she stays with the company for another 3 years, then she gets another 20,000 RSUs.
Carl is a line worker at the firm’s factory. His ESOP plan is mostly time-based. He gets 100 RSUs, if stays with the company for five years and hits the performance targets set by his immediate manager.
Tax Benefits of ESOPs
Companies have several tax incentives available to them to set up ESOPs. Their stock and cash contributions to the ESOP trust is deducted from their overall tax liabilities. Typically, ESOPs take out loans to purchase shares. These loans are also tax deductible.
In some instances, the company itself may be owned completely by the ESOP, meaning it may be wholly owned by employees. There will be no income tax applied on the company, if it is registered as an S corporation that passes on corporate income to its shareholders. Even in other cases, the percentage of the company that is held by employees is not subject to income tax.
Tax benefits from an ESOP are not limited to employers. Employees also do not have to pay taxes, if they use funds from their individual retirement accounts to contribute to an ESOP. Dividend distributions from ESOP are not taxable nor are dividend reinvestment plans. Banks can also deduct 50% of interest income from loans taken by ESOPs to finance purchase of stock.
Pros and Cons of ESOPs
The advantages of ESOP programs are as follows:
- ESOPs provide considerable tax benefits to both employees and employers.
- ESOPs provide employees with an incentive to work hard for the company’s success.
- According to research, companies with ESOP programs in place perform significantly better as compared to firms that do not have such programs in place.
The disadvantages of ESOP programs are as follows:
- ESOPs can be expensive to setup and maintain, especially for private firms that do not have many employees.
- ESOPs can turn into a losing proposition, if the company’s share price tanks.
- When ESOPs are used to boost, instead of supplementing, wages, they can reduce the overall take-home salary for expectations of future profits that may or may not occur.