There are different ways in which an employee can become an owner. For instance, they can receive a bonus, purchase stock directly, participate in a profit sharing program, be given stock options or take part in worker cooperatives. While these are all viable options, the most common method is employee stock ownership plans (ESOPs).
ESOPs first gained popularity in the 1970s and now there are thousands of plans and millions of participants. There has been misinformation provided over the years about ESOPs. The notion that they are used to rescue struggling companies is inaccurate. While that does happen, it’s rare. One of the common reasons why ESOPs are used is to reward employees. They also serve as a market for the shares of owners that have departed. However, this is when a company is successful, not when they are failing. In most cases, ESOPs are not purchased by an employee, they are instead contributed.
Snapshot of ESOP Rules
An ESOP is like a profit sharing plan in that it’s for the benefit of the employee. A trust fund is established by the company, which is where the contribution takes place. Contributions made to the trust have tax benefits, with some limitations. In fact, there are pending limitations that will commence in a couple of years. It’s anticipated that new laws will require a company to actually subtract amortization and depreciation from earnings, which must happen before they calculate interest payments.
In the event that an employee with stock departs from a company, the stock belongs to them unless the employer purchases it, which would be at fair market value. This would change under some circumstances, such as having a public market where shares are offered. When a company is private, there’s an annual valuation where the price of shares is determined. In this scenario, employees can vote on major issues.
How ESOPs Are Used
There are different ways in which ESOPs can be used. As aforementioned, they can be used to purchase shares when an owner is leaving. This enables the company to make contributions to the ESOP that are tax deductible. ESOPs are also used for the purpose of borrowing money for an after-tax price that’s lower. When that happens, a tax-deductible contribution is made later to repay the loan. Keep in mind that they are paying the interest and principle. Another way in which ESOPs are used is to offer an additional employee benefit by providing treasury shares.
Overview of Key ESOP Tax Benefits
There are a long list of tax benefits associated with ESOPs. For instance, in a C corporation, the seller is eligible for a tax deferral. Similarly, in an S corporation, the ownership percentage isn’t subject to federal taxes. In fact, there are many cases when it isn’t subject to state taxes either. Companies are able to contribute cash and take a deduction from that amount. It’s noteworthy that employees don’t pay taxes on ESOP contributions. They can also rollover distributions to a retirement plan. These are just a few of many tax benefits associated with ESOPs.
While there has been confusion about ESOPs, there are many clear benefits. Even with the limitations that exist, ESOPs are used in a way that’s beneficial to both the company and employees. The information shared only touches the surface of ESOPs because they must adhere to tax and retirement laws, which can sometimes be complex. Nevertheless, there’s a reason why ESOPs have grown in popularity for the past four decades. That interest doesn’t appear to be slowing down
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