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Employee stock ownership plans (ESOPs): How they work & the benefits

At a glance:

Employee stock ownership plans (or ESOPs) are by far the most common form of employee ownership in the United States. Over 11,000 corporations now offer these plans.

Companies offering stock ownership plans find that their employees are happier and more productive with their ESOPs than without them. ESOPs also offer significant tax and cash-flow management benefits. Employee ownership is one of the modern corporation's most popular ways of keeping loyal employees longer.

What is an employee stock ownership plan?

An employee stock ownership plan (ESOP) is an employee benefit plan that allocates company stock to employees. By receiving company shares, employees gain partial ownership of the company they work for, including voting rights.

Who can participate?

All employees age 21 and over who work 1,000 hours or more in a year must be included in the plan. Typically, the longer an employee works for a company, the more shares he or she is eligible to receive. Employees must be entitled to full ownership of the shares after working for the company for a set time (known as the vesting period).

Once an employee is fully vested in the plan, he or she owns the shares unconditionally. Employees must be 100% vested within five to seven years of service. After employees leave the company or retire, they receive their stock and can sell it back to the company for fair market value if they choose.

Where the ESOP is held

In an ESOP, a company sets up a trust fund and then contributes shares or cash to buy shares for the fund. In a trust fund, financial control of the fund's assets is in the hands of an outside trustee. The company can borrow money to buy more shares, paying the loan back with contributions to the trust. As the loan is paid back, shares are allocated to employee accounts from the trust.

(Graphic: Hannah Smart/Cashay)
(Graphic: Hannah Smart/Cashay)

ESOPs get favorable tax treatment

ESOPs are known as qualified stock plans because they meet IRS requirements to receive favorable tax treatment. Company contributions to the ESOP fund are tax-deductible within certain limits. Companies offering ESOPs must abide by federal rules preventing favoritism toward higher-paid employees. Non-qualified plans do not receive favorable tax treatment and include broad stock option plans based on a percentage of pay or merit formula.

Why are employee stock ownership plans set up?

You may already know from your own experience that people tend to work harder when they feel a sense of ownership in their jobs. Giving employees the ability to own company stock can make them feel like an important part of the company they work for, increasing their dedication and work effort.

When employees feel they are active participants in the workings and direction of their company, they are also more likely to be satisfied with their jobs, reducing turnover.

Other reasons for ESOPs

Besides the tax benefits of establishing an employee stock ownership plan (ESOP), companies also provide this plan to reduce the number of monetary bonuses they have to pay out, to borrow money on a more favorable basis, to divest or buy subsidiaries, or to buy shares from a departing owner.

Employee uses for ESOPs

Besides increased morale, the employee also gets a wide variety of benefits from participating in an ESOP. Employees can use the stock ownership to supplement their retirement plans. Employees may also receive their company shares at prices discounted below current market value. Participating in an ESOP gives employees the possibility of potential investment growth.

How employees participate

Shares of an employee stock ownership plan are allocated to employees based either on relative pay or on a level formula such as seniority. The way in which employees receive the stock may differ depending on the plan. They may buy it directly, receive it as a bonus, or gain it as part of a profit sharing plan.

When you get your money

ESOP benefits are generally paid to employees after they leave the company. The income an employee receives from an ESOP depends on the contributions made to the plan and the performance of plan investments, rather than a pre-determined benefit based on a set formula. The value of shares given to employees each year is usually different from the amount needed to pay off any outstanding trust loan used to buy more shares. If share prices rise, the value of shares given out will be higher than the amount used to pay off the loan. If they fall, it will be less.

If you leave early ...

Employees who leave the company before they are fully vested typically forfeit some or all of their shares. Some ESOP plans pay dividends to employees while they are still employed.

Tax advantages of employee stock ownership plans

Employee stock ownership plans have tax advantages for both the companies that sponsor them and for their employees. If a company's ESOP follows the rules for IRS qualification, its contributions to the ESOP trust are tax-deductible.

Companies can deduct the entire principal and interest on any loan contributions made to the ESOP. Corporate contributions to the fund are also tax-deductible at 25 percent of pay for S corporations and 25 percent of pay for C corporations. Within limitations, they can also deduct dividends that they pay out to employees.

Tax benefits for employees

Employees don't pay any income tax on their stock allocations until they begin receiving their distributions. If distributions are taken in the form of stock shares, then income tax on a portion of the value of the stock received can be further deferred until the shares are sold. Dividends received from distributed stock shares, as well as cash distributions from the plan, are taxed at ordinary income rates.

If employees receive their benefits before age 59½, they will also be charged a 10% penalty. All ESOP benefits remain tax-deferred if they are rolled over into individual retirement accounts (IRA) or qualified company plans. However, minimum required distributions must begin by April 1 of the year after which employees reach age 70½.

Summary of employee stock ownership plans

Employee stock ownership plans are an attractive way for companies to receive tax deductions, reduce turnover, increase productivity, and raise necessary capital. For employees, the opportunity to participate in an ESOP increases morale, supplements their retirement, and gives them a lasting stake in their place of employment. Both companies and their employees stand to gain important tax benefits from qualified ESOP plans.

This content was created in partnership with the Financial Fitness Group, a leading e-learning provider of FINRA compliant financial wellness solutions that help improve financial literacy.

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