Profit-sharing plans have long been popular with employees because of the opportunity they provide to share the profitability of a growing firm. Many business owners look beyond shared profitability to shared ownership through employee stock ownership plans (ESOPs).
ESOPs are essentially "defined contribution" benefit plans. However, unlike most defined contribution plans, ESOPs invest primarily in the sponsoring company's stock. This can help motivate employees, since they have an ownership stake in the company and may directly benefit from an increase in value of the company's stock. On the other hand, the level of benefits paid to plan participants is not guaranteed, and employer contributions to the ESOP can vary.
How They Work
The amount of employer and (in rare cases) employee contributions, company profitability, and administrative expenses of the plan determine the level of benefits received by participants. Employer contributions are allocated to individual employee accounts according to a specified formula. These contributions are tax deductible to the employer within certain limits.
To qualify for deductions, an ESOP must be in writing, and the sponsoring employer must establish a trust for employer contributions. Furthermore, the plan must have fiduciaries who are responsible for setting up and maintaining separate employee accounts. When properly established and maintained, the trust incurs no current income tax liability, and plan participants are not taxed on ESOP income until distributions are received. Taxation is based upon increases in the value of the stock.
Although the anti-discrimination rules of the Employee Retirement Income Security Act of 1974 (ERISA, as amended) apply, limited groups of employees can be excluded from ESOP participation. Moreover, participants can be required to satisfy a minimum period of participation before their interests in trust assets become vested (in other words, nonforfeitable). The ESOP vesting schedule specifies the percentage of assets each participant will earn upon completion of periods of service or plan participation, and the vested portion of the participant's assets is distributed as outlined in the trust document.
A Viable Option
While ESOPs may not be for all companies, their flexibility makes them a viable option for many businesses. ESOPs are often preferable to alternative forms of employee stock ownership (such as, stock purchase or stock option plans) due to their preferential tax treatment.
To promote the concept of employee stock ownership, Congress has granted a number of tax incentives to employers adopting ESOPs, including deductible ESOP contributions and dividends, tax deferrals on distributions to employees, tax-advantaged rollovers for owners selling stock to employees, and estate tax advantages.
Beyond benefits as a profit-sharing plan, the "leveraged ESOP" can be used as a financing tool to raise money for companies. In one scenario, an ESOP borrows funds from a bank to buy additional securities in the sponsoring company. Alternatively, the employer could borrow money from a bank, lend it to the ESOP, and then have the ESOP use the funds to purchase stock in the company. Business owners who are nearing retirement can also use ESOPs as a means of selling the company to employees.
When considering ESOPs, business owners are advised to analyze the potential drawbacks, including the complexity and cost of implementation. These plans may not be appropriate for every business. It is also important to consider the potential for dilution of stock value and ownership control.
When leaving the company, employees may cash in their stock or request that their share be paid out in the form of stock. Moreover, the value of an ESOP as an employee benefit may be diminished if the company's stock fails to rise according to expectations.
If these issues are properly addressed and protective measures are taken, ESOPs can offer a viable means of giving employees a stake in the company, while also providing innovative opportunities to address financial challenges.