Serving business owners since 2007An Employee Stock Option Plan (ESOP) is a tax qualified retirement plan that enables a corporation to reward and motivate employees with ownership in the corporation. Available only to corporations, ESOPs provide a number of benefits, including significant tax advantages.
However, ESOPs are not for everyone.
ESOPs are extremely complex vehicles and the following information is very general. This article is not intended as a complete guide for the decision to use an ESOP – it is provided simply to call attention to ESOPs as one of the options for a tax qualified retirement plan used by corporations.
What is an ESOP?
Operating as a trust set up by the corporation, an ESOP takes tax deductible contributions from the corporation to buy its stock, which is distributed to individual employee accounts based on established criteria such as position or pay.
Employees get the vested portion of their account upon termination, disability, retirement or death. If at that time there is no public market, the company must purchase the employee’s shares at their present valuation. The corporation is generally given the option of paying for the shares in a lump sum or in installments over a period of years.
Some Advantages of an ESOP
ESOPs almost always represent a contribution to employees rather than a purchase by employees. In some employee savings plans, corporations elect to match employee savings with stock from an ESOP rather than cash.
ESOPs provide an excellent way to both motivate and reward employees by giving them a share in the business. When the company does well, its stock becomes more valuable and the employees are rewarded.
The corporation can make tax deductible contributions of new shares of its stock or cash to purchase existing shares in the open market or from private owners. Or the ESOP can buy shares with borrowed money, allocating those shares to individual employee retirement accounts as the loan is paid. Since the corporation’s contributions to the ESOP to repay the loan are tax-deductible, both principal and interest payments on the loan are tax-deductible.
ESOPs can provide a market for shares of retiring owners, enabling them to sell their shares to the ESOP with no taxable gain on the sale. An owner who sells at least 30% of their company to the ESOP can enjoy a significant tax advantage. They are allowed to “roll-over” the proceeds into other U. S. operating companies’ securities within a prescribed time and defer taxes on the gain. And, if those securities are then left to the owner’s heirs, their cost basis, for tax purposes, is “stepped up” as of the owner’s death.
S corporations are allowed to have ESOPs. Any profits that are attributed to the ESOP’s shares are not subject to federal income tax. Therefore, where an S corp ESOP owns 100% of the company, no federal income tax is paid.
Establishing an ESOP may not mean, as one might first think, the corporation’s owners lose control of the company. In most cases, the corporation’s board of directors appoints the ESOP trustee and therefore effectively controls the ESOP’s voting.
Is an ESOP Right for You?
That is one of the more difficult questions to answer. The rules and regulations that govern ESOPs are very complicated, so establishing one will require expert professional accounting and legal advice. To get started with a very simple plan, you may need to spend $30,000 or more for qualified professional assistance and the independent stock evaluation that will be required. In short, you’re probably not going to be ready for an ESOP until your corporation is profitable and has annual revenues approaching $1,000,000.
To determine if an ESOP is right for you, you’ll need the help of a qualified ESOP specialist as you weigh the potential benefits against all of the special rules and requirements that will apply.
