ESOP Overview

An Employee Stock Ownership Plan (ESOP) in simpler terms is defined as an employee benefit plan that offers advantages to business owners and employees. This plan, according to the National Center for Employee Ownership, allows companies to set up a trust fund for employees and contribute either cash to buy company stock, contribute shares directly to the plan, or have the plan borrow money to buy shares.

It is a type of qualified retirement account that holds a portion of the company’s stock. The growth in value of the employer stock is not taxed until the funds are taken out of the ESOPs’ qualified plan.

Business Valuation Required for Employee Protection

In order to protect the employees, an independent valuation expert is required to set the overall value of the company. The company is valued at fair market value, no false highs or lows in value.

This third party valuation is a requirement per the Department of Labor (DOL), and the Internal Revenue Service (IRS). Needless to say, both organizations strive to protect the employees at all costs. Each year, a third party valuation is required to ensure enough share is allocated to each employee in the plan. Once vested an employee earns shares within the plan based on employee compensation, length of service, value of company stock, age of employee, and other factors. ESOPs protect older employees by requiring the ESOP to connect ownership in company stock to cash in order to diversify.

C Corp Owned ESOPS

The Tax Cuts and Jobs Act (TCJA) of 2017, lowered the federal rate of C Corporation tax from 34% down to 21%. With C Corporations, the business entity pays the tax and not its owners. This tax law change makes C Corporations more attractive than pass-through entities that have their owners pay these in lieu of the entity. The portion of the S Corporation owned by the ESOP does not pay tax either. In recent times, S Corporations, Limited Liability Companies (LLC) and Partnerships were very popular ownership vehicles for private businesses. There are many tax breaks available to C Corporations owned ESOPs. Some of these tax breaks are as follows:

  • Owner of closely-held C Corporations can defer taxation on gain from sale of employer stock to the ESOP if the ESOP owns 30% or more of the employer’s equity after the sale and the seller reinvests the proceeds in stocks, bonds, and other securities of U.S. operating companies within 12 months after the sale (This is not available to S Corporations).
  • ESOPs are able to borrow funds directly and subsequently use those funds to purchase stock shares from current owners. The ESOP is then able to deduct the contribution even though it used borrowed funds to acquire the stock. The ESOP then makes a contribution to the plan to repay the loan and that contribution is also deductible—both the principal and interest of the initial loan are deducible to the C Corporation.
  • Employees participating in the ESOP do not pay taxes on allocated stock until receiving distributions upon terminations of employment. (This is true for ESOPs that are S Corporations as well).
  • C Corporation employers can deduct reasonable cash dividends on ESOP stock that are used to repay the ESOP loan or passed through to participants.

 Key ESOP Benefits

ESOPs can be complex initially and to maintain, but have many long lasting benefits, such as:

  • Great tools to motivate employees as they are the owners of the business
  • ESOP employees have a true sense of ownership in company
  • This ownership drives employee engagement
  • Focuses the employees on increasing the value of the business by maximizing the assets used
  • Increased employee morale
  • Create partial or full liquidity to the selling owners
  • Create favorable financing options and tax attributes
  • Allow flexibility of ownership
  • Answer the question of searching for equity

A 2,000 Rutger study found that ESOP companies grow 2.3% to 2.4% faster after setting up their ESOP than would have been expected without it (National Center for Employee Ownership).

For further guidance on becoming an ESOP or for questions directly related to your ESOP, contact one of our advisors today.

What Is an ESOP
Infographic by National Center for Employee Ownership (NCEO) from What Is an ESOP?