A CREDO TAX PLANNING STRATEGY SOLUTION
EMPLOYEE STOCK OWNERSHIP PLAN: Understanding How It Brings Benefits to Employee Compensation, Tax Obligations, and Company Culture
Employee stock ownership plan is an attractive opportunity for company owners and employees alike as it gives employees the opportunity to be shareholders in the company to encourage them to focus on corporate performance and share price appreciation (as shares are part of the remuneration package). This whitepaper discusses the basics of ESOPs, its creation, financing, valuation and tax benefits. This guide also gives insights on how ESOP would suit exit and liquidity objectives (for valuation and selling of business purposes).
Usually, a closely held company gives employees the chance to buy shares of the corporate stock. This is done through forming an Employee Stock Ownership Plan (ESOP) with the goal of facilitating succession planning. ESOPs are trust funds that can be funded by companies through depositing newly issued shares into them, putting cash in to purchase existing company shares, or loaning money via the entity in buying company shares. Companies of all sizes (including a number of publicly traded corporations) are making use of ESOPs.
WHAT IS AN EMPLOYEE STOCK OWNERSHIP PLAN?
ESOP or an Employee Stock Ownership Plan gives employees an ownership stake in the company as a form of an employee benefit. A certain percentage of the company’s stock shares is being allocated by the employer to each eligible employee without the need of any upfront cost. The employee’s pay scale, years of service, and some other factors are basis on how the shares would be distributed. These shares are held in a trust for safety and growth until such time that the employee retires or exits from the company. The company then buys back these shares upon the exit of the employee for further distribution to the other employees.
With the goal of aligning the interests of the employees with the company’s shareholders’ interest, the employees are given a stake in the company which in turn motivates them to do what’s best for the company and its shareholders (including them as they are also shareholders).
Aside from the retirement benefits provided to employees, an ESOP is also used by company owners as an exit or liquidity vehicle. Using ESOP for this purpose provides tax benefits to the company and the selling shareholders alike.
BENEFITS OF AN EMPLOYEE STOCK OWNERSHIP PLAN
Tax Benefits for Employees
Employees enjoy some tax benefits with an ESOP as they do not pay tax on the contributions to an ESOP. They are only taxed when a distribution from the ESOP has been received upon retirement or once they exit the company. The gains accrued over time are taxed as capital gains. In the case that an employee decides to get cash distributions prior to the normal retirement age, the distributions would be subject to a 10% penalty.
Higher Employee Engagement
Higher employee engagement and involvement are seen in companies with an ESOP in place. This is because employees eventually improve their awareness on how their performance influences the company’s decisions about products and services. And since as shareholders, they can see the big picture of the company’s plans and future direction, they are more vested in making recommendations based on how they see the company can further improve. Employee trust in the company is increased with the help of an ESOP.
Positive Outcome for the Company
The adoption of an ESOP helps companies boost their annual sales growth, improve annual employment growth, and increase the company’s chance of survival. With the improvement in the organization performance of the company, the company’s share price eventually increases which then results to the growth of each employee’s balance in their ESOP account.
HOW AN EMPLOYEE STOCK OWNERSHIP PLAN WORKS
A trust must be created when creating an Employee Stock Ownership Plan where the contributions in the form of new shares of the company’s stock or cash to buy existing stock would be placed. Up to certain limits, the contributions to the trust are tax-deductible. The shares would then be allocated to the individual employee accounts with the allocation formula based on the employee’s pay scale, tenure in the company, among other factors. For new employees, usually, they are eligible for this program after rendering at least one year of service with the company.
In an ESOP, the shares allocated to the employees must vest before employees receive them. In this case, vesting means increasing rights that are conferred to the employees on their shares as they accumulate seniority in the company.
Employees who are members of the ESOP should receive their stock once they leave the company. Private companies buy back these shares at fair market value within 60 days from the employee’s departure. To determine the price of the shares, private companies need to have an annual stock valuation. Companies who have ESOP need to make sure that they enough money to pay for all the share repurchases of the longstanding employees who would have accumulated a substantial share price upon their exit.
THREE MAIN STRUCTURES OF ESOPs
Also known as non-leveraged ESOPs, employers fund the unleveraged ESOPs directly without borrowing money. To do so, they regularly contribute additional funds directly to the unleveraged ESOP. Upon issuance of the new shares of stock by the sponsoring company, a deduction for the market value would be taken for the stock that they contributed to the ESOP.
These are ESOP plans that companies grow partly or wholly through the use of borrowed funds. The money from a lender is being utilized to buy back shares from stock-owning employees once they retire or leave, and then the loan would be paid back over time in lieu of making direct contributions.
This type of ESOP involves adding new shares of stock to the trust. The sponsoring business dilutes the value of the current shares instead of contributing cash to boost the number of stocks that they can offer to new and current employees.
FACTORS TO CONSIDER WHEN IMPLEMENTING ESOPs
Midsize businesses that have the means to afford the hefty investment of a stock ownership plan benefit from implementing ESOP. For a small business, an ESOP might bring an unnecessary financial damage because an ESOP normally requires $40,000 in expenses. A company that doesn’t have a lot of employees would also be challenged logistically if they plan to have ESOP. Large companies, on the other hand, would have challenges in distributing the shares fairly to all of its employees.
A company that already has a high value would have very expensive ESOPs. The higher the valued stock, the more costly the ESOP would be as compared to a company that has a lower market value.
Companies with an already established succession planning (i.e. family businesses who have defined the transition of company ownership to a relative) is not ideal to implement ESOPs as they do not intend to pass ownership to other employees.
ESOPs can provide restraints if a business would be sold for a profit because potential buyers would need to buy out the trust. ESOPs are ideal if you don’t plan to sell the company as an exit strategy.
MORE ABOUT THE TAX BENEFITS OF ESOPs
ESOPs have a number of tax benefits. We will discuss here the tax benefits depending on the company structure.
S Corporation: The percentage owned by the ESOP does not owe income taxes if the selling company is an S corporation. This means that there are no federal income taxes (and no state income taxes on most states) for a 100% ESOP-owned S corporation. For this type in which ESOP owns a minority interest, the company can deduct contributions to the ESOP for up to 25% of the covered payroll (including all eligible retirement plans).
C Corporation: For this company structure, a company may deduct contribution up to 25% of the covered payroll if it used to make principal payments on an ESOP loan. Not similar to an ESOP that is owned by an S corporation, all contributions that are used to pay interests on an ESOP loan are not included in the limit of 25%. Yet, the interest expenses could be restricted under Internal Revenue Code (IRC) Section 163(j). Under Section 163(j), deductibility of interest expense is limited to 30% of adjusted taxable income (according to the CARES act, the limit is increased to 50% for tax years 2019 and 2020). Additional deduction of up to 25% of the covered payroll for contributions made to any qualified plan is allowed in a C corporation for as long as it is not used to repay an ESOP loan. Moreover, a C corporation may take away dividends to an ESOP plan that are beyond the contribution limits (subject to specific restrictions).
There is also an option to defer capital gains taxes of the selling shareholders through a 1042 tax deferral. This is considered as the biggest advantage in selling an ESOP to a C corporation.
DIRECT BENEFITS OF ESOPs TO EMPLOYEES
Similar to a 401(k), ESOPs allow employees to defer tax payments on the value of their ESOP contributions until the time that they retire or cash out their plan.
No-Cost Retirement Planning
There’s no cost on the part of the employees to accumulate shares of company stock.
Employees are more motivated to work and work with their employers in making the company successful since they are shareholders and own a value-accumulating part of in the business.