What is an ESOP?

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What is an ESOP?

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An ESOP is a form of employee benefit plan that invests primarily in company stock and holds its assets in a trust for employees. ESOP participants (employees) accrue shares in the plan over time and are paid out by having their shares bought back, typically after they leave the company. An ESOP may own 100% of a company’s stock, or it may own only a small percentage. ESOPs are most often used as a tax-favored way for sellers of closely held companies to transition out of ownership, but can also be used purely as an employee benefit. They are funded out of future tax-deductible dollars, not employee contributions. ESOPs are the most common form of employee ownership in the U.S. Workers at an ESOP company are partial, beneficial owners in the company. A common misconception about ESOPs is that they literally involve handing over operational control to all employees in the plans. While successful ESOPs often increase the amount of input employees give and control they have over their day to day responsibilities, there’s nothing requiring them to do so. In an ESOP, a company sets up a trust fund. Most often, the company borrows money and reloans it to the ESOP to buy shares from a seller, but the company can also make contributions of shares to the ESOP or make annual discretionary cash contributions. If the ESOP borrows money, the company makes contributions to the trust to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits. For a detailed look at how ESOPs work, see either Selling to an ESOP and Financing the Deal or Understanding ESOPs. The ESOP can buy any percentage of the company the company decides. Sellers who sell to an ESOP in a C corporation (or an S that converts to C) that owns at least 30% of the shares can defer taxation on the gain by reinvesting in stocks and bonds of U.S. operating companies. In an S corporation ESOP any profits attributable to the ESOP are not taxable. That means that a 30% ESOP is not taxable on 30% of its profits; A 100% ESOP is not taxable on any of its profits. Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within six years. In closely held companies, any share purchases or contributions must be based on a fair market valuation by an independent appraiser. The trust is governed by a trustee appointed by the board. The trustee should be an outside professional or firm for any transactions between the seller and the company but can be one or more insiders in ongoing ESOPs. The trustee is appointed by the board and votes the shares in the trust. The trustee does not get involved in the operational management of the firm. When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares. In private companies, employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the board of directors) on other issues. In public companies, employees must be able to vote on all issues. A good place to start evaluating the feasibility of an ESOP at your company is the ESOP Pre-Feasibility Toolkit.