An ESOP is an employee benefit plan that’s similar to profit sharing. In an ESOP, a company sets up a trust fund, contributing new shares of its own stock or cash to buy existing shares. Companies use ESOPs for many purposes:
- To provide a market for departing owners of closely held companies.
- To motivate and reward employees.
- To take advantage of incentives to borrow money to acquire new assets in pretax dollars.
ESOP advantages include the following:
- Contributions of stock are tax deductible. Companies get a cash flow advantage by issuing new shares or treasury shares.
- Cash contributions are deductible. Companies take a tax deduction for contributing cash on a discretionary basis year to year. This contribution can be used to buy shares from current owners or to build up a cash reserve for future use.
- ESOPs can borrow money to buy existing shares, new shares or treasury shares. ESOP financing is done in pretax dollars. Contributions used to repay the loan are tax deductible.
- ESOPs work with C or S corporations. In a C corporation, once an ESOP owns 30% of all shares in the company, the seller can reinvest the proceeds in other securities and defer any tax on the gain. In an S corporation, the percentage of ownership held by ESOPs is not subject to income tax at the federal level, nor usually at the state level. There’s no income tax on 30% of the profits of an S corporation if it’s wholly owned by its ESOP.
- Dividends are tax deductible. Reasonable dividends used to repay an ESOP loan, passed through to employees or reinvested by employers in company stock are tax deductible.
- Employees pay no tax on the contributions to the ESOP. Indeed, they can roll over their distributions into a retirement plan or pay current tax on the distribution, with any gains accumulated over time taxed as capital gains. (There’s a penalty if the income tax portion of the distribution is made before retirement age.)
- The income tax portion of the distributions is subject to a 10% penalty if made before normal retirement age.
The 2017 tax bill limits net interest deductions to 30% of EBITDA for four years, at which point the limit decreases to 30% of EBIT. Businesses then subtract depreciation and amortization before calculating their maximum deductible interest payments.
New leveraged ESOPs, in which a company borrows an amount that is large relative to its EBITDA, may find that deductible expenses will be lower, but taxable income may be higher in this situation. This doesn’t affect 100%-ESOP-owned S corporations because they don’t pay tax.
ESOP limits and drawbacks:
- The law doesn’t allow ESOPs to be used in partnerships and most professional corporations.
- Private firms must repurchase shares owned by departing employees. This can become a major expense.
- The cost of setting up an ESOP is also substantial, approximately $40,000 for the simplest plans in small companies.
- An ESOP can improve the company’s performance, but it needs to be combined with opportunities for employees to participate in decisions affecting their work.
Generally, all full-time employees over 21 years of age may participate in ESOPs. Allocations are made based on relative pay or some more equal formula. As employees accumulate seniority, they acquire the right to more shares in their account. Employees must be 100% vested within three to six years, depending on whether vesting is all at once or gradual.
When employees leave the company, they receive their stock, which the company buys back at fair market value unless there is a public market for the shares. Private companies need an annual outside valuation to determine share price. Employees must be able to vote their allocated shares on major issues such as closing or relocating, but the firm can choose whether to pass through voting rights on other issues. In public companies, employees must be able to vote on all issues.
ESOPs are the most common form of employee ownership in the U.S., with almost 6,500 plans covering 14.2 million people. With careful planning and professional advisers, an ESOP can work for you and your employees.
If you have questions, contact our office at (352) 732-4260.