ESOP refers to an employee stock ownership plan. An ESOP is a defined contribution plan but the difference between the two is the fact that a defined contribution plan is designed to make a singular investment and an ESOP is designed to invest in primarily employers stock. With an ESOP option, employees are given the opportunity to own a share in the company that they work for. In order for this to work, the company will transfer cash or shares of stock to a separate trust fund that will hold the employee shares in the company.
An employee can obtain stock by buying stock directly, obtaining it through a company bonus, receiving stock options, or obtaining stock through a profit sharing plan.
ESOPS are primarily used by companies to provide market for the shares of departing owners of successful closely held companies, motivating and rewarding employees, or to borrow money to acquire new assets in pretax dollars.
By using ESOP, the employer can both benefit the employee and benefit the company by giving the employee profit share opportunities and also being able to take cash out of the business or raise money for the purchase of equipment.
When a company has an ESOP plan qualifying employer securities, if not readily traded stock, there must be common stock with a combination of voting power and dividend right equal to or in excess of the class of common stock having the greatest voting power also the class of common stock having the greatest dividend right.
The option of ESOP is attractive to the owner of the company because it provides the owner of privately owned companies with investment diversification opportunities and enables the owners and existing management to remain after the sale. Also the ESOP option provides combined tax advantages and benefits to shareholders selling stocks and the ESOP provides the company a tax deferral on sales in certain situations.
Dividends that are paid on stock by an ESOP are tax deductible. Active employees will receive dividends directly or as a payment to the ESOP. Here, both the employees and the company will benefit when dividends are used to pay off loans, used to purchase shares, or employees may reinvest their dividends back into the companies stock.
There are many advantages that ESOPs hold for employees. Employees are eligible to purchase shares of their company when they reach the age of twenty one and also when they meet the minimum employment terms of the plan. The employee will earn more shares in the company the longer the employee stays with the company and the shares are given to the employee when the employee quits or retires from his or her place of employment. At this time, the company is required to purchase the shares back at full market value to provide the employee with retirement funds.
Unfortunately there are some disadvantages to ESOPs. First, it is very expensive for small companies to set up ESOPs for their employees. Also when a company grows and hires more employees, the stock of employees become diluted and shares become less influential. Another disadvantage is that the company must provide enough money to buy back all retiree’s shares at full price and if many employees decide to retire at the same time, this may be a difficult task for the company, especially when company funds are low. Lastly, if the company is doing very well financially, then the ESOPs are very beneficial to employees. However, if the company is doing poorly, the employees are at high risk of losing both their jobs and retirement funds simultaneously.
In order for a company to fit within the ESOP profile, the owner must desire asset diversification and want to maintain an existing company without a sale to any outsiders.
There are two ways in which an ESOP can be created. The first type of ESOP is a non leveraged option. Here, the contribution to ESOP is made in the form of employer stock or cash, which is sold by the ESOP to acquire employer stock. The second option is a leveraged ESOP. Here a loan is made to an ESOP and used by the ESOP to acquire employer stock which is basically borrowed money.
In a basic Leverage Transaction, the company borrows money and then lends money or the loan that the bank borrowed proceeds to ESOP. The ESOP uses the borrowed funds to purchase company stock and then the selling shareholder transfers his stock to the ESOP.
Although an ESOP option is very appealing to most employers, the government limits which companies can provide this option. Partnerships and most professional corporations are not permitted to use ESOPs. ESOPs can be used in S corporations and private companies must repurchase shares of departing employees, which is very expensive. Also it is very expensive for setting up an ESOP program.
