What Businesses Need to Know About Employee Stock Ownership Plans
What is an Employee Stock Ownership Plan?
An Employee Stock Ownership Plan is a compensation program that uses a trust to invest and distribute financial benefits to members within the trust group. By law this type of program has to invest the majority of its funds in securities of the company. Contributions made to this trust can be made by either the company or by qualified employees. Contributions made by employees are considered tax free dollars, and therefore this compensation plan offers a tax savings advantage for employees. The employer’s contributions to the trust fund are distributed to individual employee accounts based on the compensation structure created by the company. This structure is based on seniority, position, and salary.
Employees can cash out their accounts after they have become vested. However, the amount of their withdrawal will depend on the vesting rules that are attached to the trust. When the employee reaches the age of 55 they can diversify 25% of their Employee Stock Ownership Plan, as long as they have been in the program for at least ten years. Their next opportunity to diversify will occur when they turn 60 years of age. At this milestone they will have a single opportunity to diversify up to 50% of their account. The employee can withdraw the vested portion of their ESOP when they retire, when their employment is terminated, or if they become disabled. In the event of their death the vested proceeds will be transferred to their estate.
Pros and Cons of an Employee Stock Ownership Plan
An Employee Stock Ownership Plan has many advantages for both participating employees and employers. The ESOP offers business owners the unique opportunity to finance their company’s operations by borrowing from the ESOP. In addition to this advantage ESOPs also provide companies with several tax advantages. First business owners can sell portions of their company to employees in the form of stock through the ESOP, while still retaining control of the company. Upon retirement the company simply buys back the stock. These stocks can then be sold to new ESOP members. Furthermore, the money gained from the conversion of company ownership to employee stock options is not seen as income, instead it is seen as an untaxable capital appreciation. Also if the company decides to sell between 30 and 100% of their company to their ESOP then they can use the money from that sale to purchase other securities which will allow them to defer the tax liability to a later date.
For employees, the benefits of ESOPs are simple. First employee contribution to ESOPs are not taxed. Secondly employees gain partial control of their account at ages 55 and 60, which allows them to diversify their investments. Finally, they gain partial ownership of the company that they work for, which is a moral booster and it will help to improve the employee’s feelings of job satisfaction.
While an ESOP has many obvious advantages, it also has a few drawbacks. If the stock market takes a turn for the worse and the company’s stock fails to perform well, employees may see the ESOP as a poor investment and they may feel that a profit sharing situation would be more beneficial to them. On the other hand, if the stock performs well, then company may not have enough liquid assets to cover the cost of repurchasing the stock from retiring employees. Another disadvantage of an ESOP is that the people who oversee the program and its management are considered the fiduciaries of the trust and they are therefore held liable for misuse and mismanagement of the ESOP accounts. This can place the company in financial and legal jeopardy if an unscrupulous or incompetent ESOP manager fails to oversees the company’s ESOP properly.
