Employee Stock Ownership Plan (ESOP)
What It Is:
An defined contribution plan whereby the employer invests the assets in the employer’s .is a
How It Works/Example:
To establish an ESOP, a company first establishes a trust in which the company’s employees are partial owners. The trust purchases shares of the company (and in some cases, other assets). These contributions (and subsequent purchases of stock) are allocated to individual employee accounts within the ESOP. Companies can allocate contributions to employees in a number of ways, but they usually revolve around the employee’s years of service and compensation.
A formal plan document sets forth the and conditions of the ESOP. Private companies must also get an independent appraiser to assign a value to the company’s shares before the shares enter the ESOP. The ESOP’s plan document describes how the plan operates, who is eligible to participate, and who performs administrative and functions. The trustee actually holds the ESOP shares and has a fiduciary responsibility to manage the ’s assets effectively; the administrator maintains records, calculates , and tracking account values. Once the company formally adopts the ESOP and the related trust documents, it submits them to the . The IRS then determines whether the ESOP receive a tax-qualified status.
ESOPs must meet several requirements of the Internal Code and the Employee Retirement Income Security Act of 1974 (ERISA) to become a qualified retirement plan. There are four major tax benefits associated with these plans: Employers can deduct plan contributions (up to a limit);employees can defer on the contributions and their until they withdraw their ; the employer does not pay taxes on the ESOP’s dividends while those earnings are in the fund; and employees can often transfer ESOP balances into other tax-deferred vehicles, such as IRAs, to further defer taxation.
ESOP contributions must vest at least 20% per , although another is to no vesting in the first years and then 100% vesting within three years. When an employee leaves the company, the employee receives his or her vested balance either in shares or in .
Why It Matters:
Most companies create ESOPs to provide the motivation, inspiration and retention associated with ownership. Like other defined contribution plans, the ultimate benefit to the employee depends on the amount contributed and the performance of the in the . participants and sponsors can enjoy some unique tax advantages, but ESOPs also tend to more risk than other defined contribution plans, such as 401(k)s, because they generally do not diversify their holdings. Businesses often use ESOPs as collateral to obtain financing for acquisitions and other activities. Additionally, when ESOPs new , they can dilute existing shareholders.
Privately-held companies with ESOPs have a repurchase obligation to departing employees, meaning that the employer must purchase the employee’s ESOP shares within 60 days of the employee’s departure from the company. Over time, this obligation can become quite large (especially if the price increases substantially), and companies must ensure that they have enough to meet their obligations in these situations.