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02/04/2016

HowanEmployeeStockOwnershipPlan(ESOP)Works

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HowanEmployeeStockOwnershipPlan(ESOP)Works
ESOPsProvideaVarietyofSignificantTaxBenefitsforCompaniesandTheirOwners.ESOPRulesAre
DesignedtoAssurethePlansBenefitEmployeesFairlyandBroadly

Employeeownershipcanbeaccomplishedinavarietyofways.Employeescanbuystockdirectly,be
givenitasabonus,canreceivestockoptions,orobtainstockthroughaprofitsharingplan.Some
employeesbecomeownersthroughworkercooperativeswhereeveryonehasanequalvote.Butbyfar
themostcommonformofemployeeownershipintheU.S.istheESOP,oremployeestockownership
plan.Almostunknownuntil1974,by20147,000companieshadESOPscovering13.5million
employees.
CompaniescanuseESOPsforavarietyofpurposes.Contrarytotheimpressiononecangetfrommedia
accounts,ESOPsarealmostneverusedtosavetroubledcompaniesonlyatmostahandfulofsuch
plansaresetupeachyear.Instead,ESOPsaremostcommonlyusedtoprovideamarketforthesharesof
departingownersofsuccessfulcloselyheldcompanies,tomotivateandrewardemployees,ortotake
advantageofincentivestoborrowmoneyforacquiringnewassetsinpretaxdollars.Inalmostevery
case,ESOPsareacontributiontotheemployee,notanemployeepurchase.

ESOPRules
AnESOPisakindofemployeebenefitplan,similarinsomewaystoaprofitsharingplan.InanESOP,
acompanysetsupatrustfund,intowhichitcontributesnewsharesofitsownstockorcashtobuy
existingshares.Alternatively,theESOPcanborrowmoneytobuyneworexistingshares,withthe
companymakingcashcontributionstotheplantoenableittorepaytheloan.Regardlessofhowtheplan
acquiresstock,companycontributionstothetrustaretaxdeductible,withincertainlimits.
Sharesinthetrustareallocatedtoindividualemployeeaccounts.Althoughtherearesomeexceptions,
generallyallfulltimeemployeesover21participateintheplan.Allocationsaremadeeitheronthebasis
ofrelativepayorsomemoreequalformula.Asemployeesaccumulatesenioritywiththecompany,they
acquireanincreasingrighttothesharesintheiraccount,aprocessknownasvesting.Employeesmust
be100%vestedwithinthreetosixyears,dependingonwhethervestingisallatonce(cliffvesting)or
gradual.
Whenemployeesleavethecompany,theyreceivetheirstock,whichthecompanymustbuybackfrom
thematitsfairmarketvalue(unlessthereisapublicmarketfortheshares).Privatecompaniesmust
haveanannualoutsidevaluationtodeterminethepriceoftheirshares.Inprivatecompanies,employees
mustbeabletovotetheirallocatedsharesonmajorissues,suchasclosingorrelocating,butthe
companycanchoosewhethertopassthroughvotingrights(suchasfortheboardofdirectors)onother
issues.Inpubliccompanies,employeesmustbeabletovoteallissues.

UsesforESOPs
1.Tobuythesharesofadepartingowner:OwnersofprivatelyheldcompaniescanuseanESOPto
createareadymarketfortheirshares.Underthisapproach,thecompanycanmaketaxdeductible
cashcontributionstotheESOPtobuyoutanowner'sshares,oritcanhavetheESOPborrowmoney
tobuytheshares(seebelow).
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02/04/2016

HowanEmployeeStockOwnershipPlan(ESOP)Works

2.Toborrowmoneyataloweraftertaxcost:ESOPsareuniqueamongbenefitplansintheirabilityto
borrowmoney.TheESOPborrowscash,whichitusestobuycompanysharesorsharesofexisting
owners.ThecompanythenmakestaxdeductiblecontributionstotheESOPtorepaytheloan,
meaningbothprincipalandinterestaredeductible.
3.Tocreateanadditionalemployeebenefit:Acompanycansimplyissuenewortreasurysharestoan
ESOP,deductingtheirvalue(forupto25%ofcoveredpay)fromtaxableincome.Oracompanycan
contributecash,buyingsharesfromexistingpublicorprivateowners.Inpubliccompanies,which
accountforabout5%oftheplansandabout40%oftheplanparticipants,ESOPsareoftenusedin
conjunctionwithemployeesavingsplans.Ratherthanmatchingemployeesavingswithcash,the
companywillmatchthemwithstockfromanESOP,oftenatahighermatchinglevel.

MajorTaxBenefits
ESOPshaveanumberofsignificanttaxbenefits,themostimportantofwhichare:
1.Contributionsofstockaretaxdeductible:Thatmeanscompaniescangetacurrentcashflow
advantagebyissuingnewsharesortreasurysharestotheESOP,albeitthismeansexistingowners
willbediluted.
2.Cashcontributionsaredeductible:Acompanycancontributecashonadiscretionarybasisyearto
yearandtakeataxdeductionforit,whetherthecontributionisusedtobuysharesfromcurrent
ownersortobuildupacashreserveintheESOPforfutureuse.
3.ContributionsusedtorepayaloantheESOPtakesouttobuycompanysharesaretaxdeductible:
TheESOPcanborrowmoneytobuyexistingshares,newshares,ortreasuryshares.Regardlessof
theuse,thecontributionsaredeductible,meaningESOPfinancingisdoneinpretaxdollars.
4.SellersinaCcorporationcangetataxdeferral:InCcorporations,oncetheESOPowns30%ofall
thesharesinthecompany,thesellercanreinvesttheproceedsofthesaleinothersecuritiesanddefer
anytaxonthegain.
5.InScorporations,thepercentageofownershipheldbytheESOPisnotsubjecttoincometaxatthe
federallevel(andusuallythestatelevelaswell):Thatmeans,forinstance,thatthereisnoincome
taxon30%oftheprofitsofanScorporationwithanESOPholding30%ofthestock,andnoincome
taxatallontheprofitsofanScorporationwhollyownedbyitsESOP.Note,however,thattheESOP
stillmustgetaproratashareofanydistributionsthecompanymakestoowners.
6.Dividendsaretaxdeductible:ReasonabledividendsusedtorepayanESOPloan,passedthroughto
employees,orreinvestedbyemployeesincompanystockaretaxdeductible.
7.EmployeespaynotaxonthecontributionstotheESOP,onlythedistributionoftheiraccounts,and
thenatpotentiallyfavorablerates:TheemployeescanrollovertheirdistributionsinanIRAorother
retirementplanorpaycurrenttaxonthedistribution,withanygainsaccumulatedovertimetaxedas
capitalgains.Theincometaxportionofthedistributions,however,issubjecttoa10%penaltyif
madebeforenormalretirementage.
Notethatallcontributionlimitsaresubjecttocertainlimitations,althoughtheserarelyposeaproblem
forcompanies.

Caveats
Asattractiveasthesetaxbenefitsare,however,therearelimitsanddrawbacks.Thelawdoesnotallow
ESOPstobeusedinpartnershipsandmostprofessionalcorporations.ESOPscanbeusedinS
corporations,butdonotqualifyfortherollovertreatmentdiscussedaboveandhavelowercontribution
limits.Privatecompaniesmustrepurchasesharesofdepartingemployees,andthiscanbecomeamajor
expense.ThecostofsettingupanESOPisalsosubstantialperhaps$40,000forthesimplestofplans
insmallcompaniesandonupfromthere.Anytimenewsharesareissued,thestockofexistingowners
isdiluted.ThatdilutionmustbeweighedagainstthetaxandmotivationbenefitsanESOPcanprovide.
Finally,ESOPswillimprovecorporateperformanceonlyifcombinedwithopportunitiesforemployees
toparticipateindecisionsaffectingtheirwork.
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HowanEmployeeStockOwnershipPlan(ESOP)Works

ForabooklengthorientationtohowESOPswork,seeUnderstandingESOPs.
Returntoregularversion

TheNationalCenterforEmployeeOwnership(NCEO)1629TelegraphAve.,Suite200Oakland,CA
94612Phone5102081300Fax5102729510Websitehttp://www.nceo.org/Email:
customerservice@nceo.org.Allmaterialonthissiteis2016byNCEO.

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