Employee Stock Ownership Plan
Employee Stock Ownership Plans or ESOPs are, in the U.S., formal structures for company that is owned in all or in part by its employees. Such employee-owned corporations often adopt profit sharing where the profits of the corporation are shared with the employees. They also often have boards of directors elected directly by the employees.
Establishing an ESOP
To establish an ESOP, a firm sets up a trust and makes tax-deductible contributions to it. All full-time employees with a year or more of service are normally included. The ESOP can be funded through tax-deductible corporate contributions to the ESOP. Discretionary annual cash contributions are deductible for up to 55% of the pay of plan participants and are used to buy shares from selling owners. Alternatively, the ESOP can borrow money to buy shares, with the company making tax-deductible contributions to the plan to enable it to repay the loan. Contributions to repay principal are deductible for up to 25% of the payroll of plan participants; interest is always deductible. Dividends can be paid to the ESOP to increase this amount over 25%. Sellers to an ESOP in a closely held company can defer taxation on the proceeds by reinvesting in other securities. In S corporations, to the extent the ESOP owns shares, that percentage of the company's profits are not taxed: 100% ESOPs pay no federal income tax. Employees do not pay taxes on the contributions until they receive a distribution from the plan when they leave the company; even then they can roll the amount over into an IRA.
Stock acquired by the ESOP is allocated to accounts for individual employees based on relative pay or some more equal formula. Accounts vest over time, usually following one of two formulas: in the first, vesting starts at two years and completes at six; in the second, participants become 100% vested after four years. When employees leave the company, they receive their vested ESOP shares, which the company or the ESOP buys back at an appraised fair market value. ESOP participants must be allowed to vote their allocated shares at least on major issues, such as closing or selling the company, but are not required to be able to vote on other issues, such as choosing the board.
Employees also can acquire stock through grants of stock options, the right to buy shares at a price set today for a defined number of years into the future. There are no special tax benefit associated with most forms of stock options, however. Employees can also become owners by purchasing shares in a stock purchase program, usually at a discount, by buying stock in their 401(k) savings plans, or by companies making matches of company stock to employee deferrals into these plans. Stock in 401(k) plans can be bought with pretax income, while company contributions are tax-deductible.
Disadvantages to Employees
Employee ownership in 401(k) plans is problematic. About 17% of total 401(k) assets are invested in company stock—more in those companies that offer it as an option (although many do not). This may be an excessive concentration in a plan specifically meant to be for retirement security.
Accounting for ESOPs
ESOPs in the U.S. are not subject to the accounting rules for stock option plans and other equity instruments. ESOPs in the U.S. are a specific kind of plan set up by U.S. law. The term "ESOP" is often used generically for employee ownership, especially in India, where it refers to employee stock option plans.
- ESOP Association - The ESOP Association, founded in 1978, is a national non-profit membership organization, with 18 local Chapters, serving approximately 2,500 employee stock ownership plan (ESOP) companies, professionals with a commitment to ESOPs, and companies considering the implementation of an ESOP.
- Employee Ownership Foundation - The Employee Ownership Foundation's (EOF) primary purpose is to support programs that will increase the level of awareness and appreciation of the benefits of employee ownership and increase the number of employees who have access to this benefit.
- National Center for Employee Ownership - NCEO is a private, nonprofit membership and research organization that serves as a source of information on employee stock ownership plans, equity compensation plans such as stock options, and ownership culture.