Pin Me

Explaining ESOPs or Employee Stock Ownership Plans

written by: •edited by: Michele McDonough•updated: 5/27/2010

What is an employee stock ownership plan or ESOP? For the small business owner, it can be a way to offers stock shares of your business to employees or enable employees to purchase the business if you’re near retirement.

  • slide 1 of 4

    What is an ESOP?

    Allied Paper Stock Certificate 1964 Wikimedia Commons ESOPs or employee stock ownership plans can be beneficial for business owners and employees in one of two ways:

    • Retirement Benefit – As a retirement benefit, once the ESOP is set up by and is appointed a trustee, employees can make contributions of up to 15% of each pay check to purchase shares of stock. Upon retirement, or at the age of 55, employees usually sell the stock back to the company. Contributions are exempt from federal and some state taxes and the employee who receives cash for his stock share investment can opt to turn that money into an IRA or equivalent for the future with no tax penalties on capital gains.
    • Buying Out the Owners – Long-term employees often like the choice of enrolling in an ESOP especially if the owners want to sell the business to their employees upon retirement. In this instance, company stock shares are distributed to participating employees based on amounts obtained through contributions and in essence; the employees become the owners of the company. In this type of ESOP, the employee can make contributions of up to 25%.
  • slide 2 of 4

    Where’s the Catch?

    Because ESOPs were first utilized in larger corporations and are now becoming popular for the small business owner, ESOPs can be expensive to set up and audit. They are regulated by rules from the federal government including reporting, setup, analysis, and/or auditing.

    The owners of a company must pay for audits, reports and setup, all of which are tax deductible, however, misuse of funds by the ESOP trustee is sometimes a threat to employee contributors.

    Employees should be given ample time and adequate information before buying into an ESOP. If the company needs the money to help it from going out of business, this is not a good idea. If a company with an ESOP goes bankrupt, all the contributions are lost. The upside to this is that the federal government, to ensure the safety of the ESOP, won’t allow business owners to set up an ESOP unless they have been in business for at least three years and have been profitable in each of those three years.

    A business owner who establishes an ESOP for their employees may also opt to utilize the employee contributions to expand the business in a loan form without interest. This is legal but the owners of the company must be able to pay back the cash equivalent or stock shares achieved upon retirement.

    Expanding the business through an ESOP can also beneficial for the long-term employees who will someday takeover the business through stock share options. Current owners of the ESOP are given tax breaks in ESOP loan expansions and aren’t required to repay any interest into the ESOP plan when repaying the loan.

  • slide 3 of 4

    The Advantages of an ESOP

    Employees Bid FEMA Administrator Farewell Wikimedia Commons Setting up an ESOP, especially for employee buyout purposes, can boost employee morale. Employees tend to feel that you trust them to takeover the business you’ve grown and developed and possibly carry it to the next level.

    There are no taxes incurred by the employee on contributions and if a cash equivalent is paid out instead of stock, if the employee rolls the cash into retirement plan venue, there is also no tax.

    Depending upon how the ESOP is set up, dividend shares are possible to the employees prior to retirement or company takeover. Dividends are also tax-free.

    For private or family owned businesses with no one to take over leadership, this can ensure your company lives on.

    If you own a small company and put an ESOP in place, larger company mergers or acquisitions are almost impossible. This is a good way to protect your small business.

  • slide 4 of 4

    Where to Find Help on ESOPs

    Most accounting firms are able to set up ESOPs and can even become the plan’s trustee. This is often the best route to take as it ensures employee confidence and can boost morale. For instance, an ESOP owner who is also the trustee may opt to use funds to invest in other companies or the stock market. While this is disallowed, unless an audit reveals it, contributed dollars could be lost.

    If you are interested in providing your employees with pride in company ownership or a unique way to offer retirement funds without taxation, ask your accountant if he or she can help or refer you to an accounting firm who specializes in ESOPs.