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How do ESOPs work?

Employee Stock Ownership Plans (ESOPs) are also known as Employee Share Ownership Plans. ESOPs provide a company’s workforce with an ownership interest in the company by allowing them to provide their employees with stock ownership, often at no up-front cost to the employees.

ESOP shares, however, are part of employees’ remuneration for work performed. They’re allocated to employees and may be held in an ESOP trust until the employee retires or leaves the company. The shares are then sold. ESOPs are regulated by Employee Retirement Income Security Act (ERISA), a federal law that sets minimum standards for investment plans in private industry.


7 Key ESOP Points

  1. ESOPs are a highly-tax-favored way for employees to share ownership in their company through a trust fund.
  2. Companies make tax-deductible contributions to the ESOP. Contributions are either allocated to participant accounts or used to repay the ESOP loan.
  3. When a portion of the ESOP loan is paid, a portion of the shares is allocated to participant accounts.
  4. ESOPs allocate shares to each eligible employee every year, giving employees an increasing ownership stake as they gain seniority.
  5. The ESOP distributes these shares to employees to fund their retirement.
  6. All ESOP rules balance two competing interests—that they’re flexible enough so that employers will be willing to set an ESOP, but not so flexible that they’re easy to abuse.
  7. An ESOP company is worth what a willing buyer would pay for the company to have the rights to its future earnings and its current assets.


How does an ESOP work for employees?

An ESOP opens when a company sets up a trust and makes tax-deductible contributions to it. Each company needs to determine how to allocate ESOP shares to each employee. Some employers look at years of service, while others look at annual compensation. These factors and others can be combined into an allocation formula to divide up the stock into each employee’s account.

Once the ESOP allocation formula is determined, a vesting formula also must be created. This formula will determine how the employees’ share value will be calculated upon leaving the ESOP. ESOPs must not discriminate in their operations in favor of highly compensated employees, officers, or owners. In an ESOP, a company sets up an employee benefit trust, which it funds by contributing cash to buy company stock, contributing shares directly, or having the trust borrow money to buy stock. Generally, at least all full-time employees with a year or more of service may participate in an ESOP.

ESOPs allow employees to defer taxes on the contributions until they receive a distribution from the plan when they leave the company. They can roll the ESOP funds over into an Individual Retirement Account (IRA), as can participants in any qualified plan.


How does an ESOP work for business owners?

All ESOPs are governed by trustees that have a fiduciary duty to administer the trust and oversee the plan. ESOP trustees are typically upper management in the company. An ESOP can be used to finance ownership transition, raise new equity capital, refinance outstanding debt, or acquire productive assets. ESOPs can also be used to increase cash flow by making plan contributions in stock instead of cash. ESOP contributions are fully tax deductible, allowing employers to fund both the principal and the interest payments on ESOP debt service with pre-tax dollars.


How does an ESOP work for stockholders?

One of the most popular uses for an ESOP is to provide a ready market for some or all of the shares owned by shareholders in a closely held company. With an ESOP in place, a majority or controlling shareholder has an exit strategy when he or she is ready to retire. Likewise, an ESOP is often an attractive buyer for a minority shareholder in a closely held company. With an ESOP, a majority shareholder has the option of selling only a portion of his or her stock to increase personal liquidity while maintaining control of the company.

Ascensus Sales Team

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