ESOP stands for Employee Stock Ownership Plan. These ESOPs have rules for their plans that are made ensure that the employees will benefit broadly and fairly. They can offer a diverse selection of tax benefits for companies and the company’s owners.
When an employee is able to buy stock directly from his company, this makes him gain ownership in the company. Several ways that this can occur include receiving stock options, gaining stock with a profit sharing plan or getting it in a bonus. There are some instances where the employees can become owners with all of them having an equal vote in a worker cooperative. However, the ESOP is becoming the most popular way for an employee to have ownership in the United States. The ESOP began back in 1974 and has grown to cover at least 14 million people with over 6,000 plans.
Companies can benefit from ESOPs in many ways. They are mostly used to offer a market for the stock shares of former owners productively held companies, to take advantage of ways to borrow cash for gaining new assets with pretax dollars, or to reward and motivate employees. Most of the time the ESOPs are not a purchase by an employee but are an employee’s contribution.
An ESOP must have rules that let it perform very much like a profit-sharing plan as it is a benefit plan for the employee. To get it started, the company will set up a trust fund. Then the company will contribute cash to purchase existing shares or will have new shares which it can contribute out of its own stock. The ESOP can also borrow the money needed to purchase existing or new shares. In this scenario, the company will make monetary contributions to the ESOP plan that lets the loan be repaid. In either method, the company’s contributions will be tax deductible in some cases.
There are several important uses for ESOPs. They can be used to purchase shares of an owner who is leaving. Money can be borrowed at an after tax cost that is lower. The ESOPs are very beneficial to the company’s employees. They can help the employee along with the savings plans offered by the company. ESOPs match the employees with stock and the savings plans are matched with cash. The stock match is usually higher than the match made with cash.
There are also great tax benefits due to ESOPs. Both cash and stock contributions are tax deductible. Repaying a loan with contributions are tax deductible. A tax deferral can be acquired for C corporation sellers. For those in an S corporation, the ESOP percent of ownership does not need to pay federal income tax, and usually not state tax either. The dividends earned are tax deductible. Employees only need to pay taxes for their ESOP distribution and these could be a favorable rates.
Even though there are several tax benefits, there are still limitations. ESOPs are not allowed to be used in many professional corporations and in partnerships. They also may have lower limits for contributions and aren’t qualified for the rollover treatment. It may also be expensive to set up an ESOP with a minimum figure of $40,000 for simple plans and could be much higher than that for larger plans with larger companies.
Another negative aspect is when there are new shares being issued, the existing owners with stock may have theirs diluted. The best way the ESOPs will improve performance is when they can be combined with employee opportunities to add to the decisions that affect their jobs.
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