Although technically only in existence since 1974, the concept of Employee Stock Ownership Plans has been in the law since 1921 in the form of Stock Bonus Plans. Stock Bonus Plans, like Employee Stock Ownership Plans, are tax-exempt trusts which are designed to enable employees to own part or all of the company for which they work, without investing their own funds. The distinguishing feature of an ESOP is that an ESOP, unlike a Stock Bonus Plan, may engage in “leveraged” purchases of company stock. That is, an ESOP may acquire stock not only on a year-by-year basis, but also may borrow funds in order to purchase a block of stock.
From 1974 to date, it has been estimated that 20,000 companies have installed Employee Stock Ownership Plans. The total number of employees currently covered by ESOPs is about 13,500,000.
Learn the basics about Employee Stock Ownership Plans:
What is an ESOP?
ESOP Definition: “ESOP” is an acronym that stands for Employee Stock Ownership Plan. Technically, the Plan is operated or administered pursuant to a tax-exempt Trust, referred to as ESOT, Employee Stock Ownership Trust. Accordingly, the Plan is alternatively referred to as the ESOP or the ESOT.
The purpose of an ESOP is to enable employees to acquire beneficial ownership in their Company without having to invest their own money.
The Plan is also a tax-exempt entity for Federal and state corporate income tax purposes. This enables the Company to make cash and/or Company stock contributions to the Trust, which are used to acquire stock of the Company on behalf of its employees. The advantage of the ESOP is that employees are able to acquire this stock without paying a current income tax on the stock. Again, this results from the fact that the contribution is made entirely by the Company and is not taxed to employees personally as it is allocated. The advantage to the Company is that the ESOP makes pre-tax dollars available to finance Company growth and/or to create ownership liquidity at the time of retirement.
Because employees are not taxed currently on the stock which is acquired for their benefit, they are able to acquire up to twice the amount of stock which they could acquire if a Trust arrangement were not used. That is, if shares of stock were issued to an employee by the Company, that employee would be taxed currently on the value of those shares. Also, if an employee buys stock directly from the Company or other shareholders, that employee is using “after-tax” funds rather than pre-tax dollars. The use of a Trust eliminates this tax problem since the Trust is not taxable and frees employees from income tax liability until the shares are distributed.
What are the Tax and Financial Advantages of an ESOP?
The ESOP enjoys a number of tax and financial advantages not enjoyed by other types of buyout alternatives, including the following:
- Under Section 1042 of the Internal Revenue Code, if the ESOP acquires 30% or more of the outstanding stock of a privately-held company, any capital gains tax on the transaction is deferred indefinitely, provided that the seller reinvests the proceeds in “qualified replacement property” within 12 months of the date of sale.
- Unlike a sale or merger, the ESOP enables the seller to sell any portion of his or her stock. A sale or merger usually requires the seller to sell 100% control.
- The ESOP enables the company to repay principal with tax-deductible dollars.
- Dividends paid on stock held by an ESOP are fully tax-deductible, provided that such dividends are either passed through to participants or are used to make principal or interest payments on an ESOP loan.
- In the case of an S corporation, the ESOP’s share of S corporation earnings is not subject to federal or state* corporate taxation or to taxation as “unrelated business income tax,” unless the ESOP runs afoul of certain “anti-abuse” provisions. Thus, in the case of an S corporation that is 100% owned by its ESOP, the company’s earnings will be entirely tax-exempt.
- An ESOP enables an owner to keep control until he is ready to fully retire. When the owner does retire, the ESOP enables the owner to pass control to his key employees.
- An ESOP enables an owner to provide for business continuity for the business that he has grown and nurtured over many years. Unlike a sale or merger, an ESOP enables a company to retain its separate identity rather than become a branch or division of a larger company.
- An ESOP enables a company to attract, retain and motivate key employees.
- Studies have shown that ESOP-owned companies become more productive and profitable than comparable firms in the same industry that are not ESOP-owned.
- An ESOP can be used to enable a company to make acquisitions of other companies with tax-deductible dollars. In addition, by using an ESOP the sellers can receive their proceeds tax-free under the provisions of Section 1042 of the Code.
*However, there are one or two states that arguably do not follow federal law with respect to the tax treatment of S corporation distributions received by an ESOP.
Why Should Your Company Adopt an ESOP?
The following advantages are material to the adoption of the Plan.
- The ESOP will enable the Company to buy out the current owners, using tax-deductible Company contributions.
- The ESOP will enable the employees to share in the current and future economic rewards of ownership.
- An ESOP will be a better incentive plan for employees than other alternatives.
The flexibility of the ESOP to not only invest in the stock of its own Company but to diversify its investments over a broad range of opportunities makes it a valuable retirement asset.
The term “Employee Stock Ownership Plan” was first defined by Federal legislation in the Employee Retirement Income Security Act of 1974. Thus, in a sense, the ESOP is a relatively new form of plan which has existed only since September 2, 1974 when ERISA was enacted into law. In the Tax Act of 1978, ESOPs are defined as “. . . a technique of Corporate Finance. . .” Thus their purpose of benefiting both employees and the Company has been clearly defined by Congress. From 1974 through 1989, it has been estimated that 12,000 companies have installed Employee Stock Ownership Plans. This brings the total number of employees covered by ESOPs to more than 11,000,000. However, many ESOPs existed prior to 1974, even though such plans were not defined by Federal statute. Employee Stock Ownership Plans were first recognized by the Internal Revenue Service in 1952 and 1974.
Although technically only in existence since 1952, the concept of Employee Stock Ownership Plans has been in the law since 1921 in the form of Stock Bonus Plans. Stock Bonus Plans, like Employee Stock Ownership Plans, are tax-exempt trusts which are designed to enable employees to own part or all of the company for which they work, without investing their own funds. The distinguishing feature of an ESOP is that an ESOP, unlike a Stock Bonus Plan, may engage in “leveraged” purchases of company stock. That is, an ESOP may acquire stock not only on a year-by-year basis, but also may borrow funds in order to purchase a block of stock.
What is the Philosophy of the ESOP
A. Broaden Ownership of Capital
The ESOP is sometimes referred to as the Industrial Homestead Act. ESOP legislation, like the original Homestead Act, is designed to broaden the ownership of capital by employees. The Homestead Act had an enormous impact upon the growth and success of the American economy. During the first half of the twentieth century, land represented the major source of wealth in the American Economy. Land represented an underdeveloped capital resource, which needed the elements of labor and tools in order to make it productive. In order to encourage the further development of this natural resource, the Homestead Act provided that any person could “homestead” up to 160 acres per person. The law provided that any person who took possession of the land and assumed responsibility for making it productive for a certain period of years would acquire full ownership of this land at the end of that time. As a result of this legislation, hundreds of thousands of people were able to acquire capital and to become financially independent. During the past thirty years, however, the nature of the economy has shifted from an agricultural economy to an industrial economy. As a consequence, the source of wealth has shifted from ownership of land to ownership of corporate stock. The Employee Stock Ownership Plan, like the Homestead Act, is designed to enable employees to benefit from the ownership of capital through the investment of their talent and energy.
B. Create Financial Security
The second goal of Employee Stock Ownership plans is to create a source of income which can be used to supplement Social Security and other retirement plans.
Sound financial planning requires that every person make some financial plans for the future. Financial need can arise in the future due to retirement, disability, or increased cost of living. In order to adequately provide for these financial hardships, each person should attempt to accumulate a “nest egg” or financial reserve which can be used to meet these needs.
For most employees, saving money from after-tax dollars is virtually impossible, due to the increasing burden of inflation and of Federal and state income taxes.
An ESOP can provide a capital accumulation for each employee in addition to his or her normal salary. Because this capital accumulation is not taxed at the time of contribution, this capital amount can accumulate at a faster rate than if it were taxed each year as it is contributed to the plan.
In addition, the advantage of stock ownership is that stock investments have the potential for appreciation and for capital gains which savings accounts and other forms of fixed income investments do not possess. To the extent that the ESOP is invested in the stock of the Company, employees will have a direct influence on its value by their work performance.
In a nutshell, it is generally easier to create a “nest egg” by means of investments than it is to create a “nest egg” out of annual wages.
C. Create Better Incentives and Urge Better Employee Productivity.
The third goal of Employee Stock Ownership Plans is to encourage and reward increased employee productivity and efficiency. Increased employee productivity and efficiency is one of the largest variables in the overall profitability of any company. In many instances, a 5% or 10% increase in individual employee productivity may result in increasing company profitability by 50% or more. The goal of the ESOP is to reward employees for their efforts so that they automatically share in the growth of the company. The ESOP creates a direct link between employee productivity and employee benefits.