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Employee Stock Ownership Plan (ESOP)

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Image shows a binder with the title page reading, "Employee Stock Ownership Plan."

Employee benefits can cover many types of perks that a worker can receive from a company — including health insurance, paid time off, family leave, professional development and more. For employees who are looking to be able to enjoy an actual stake in the company — and company owners who wish to find a way to offer ownership to workers — an employee stock ownership plan (ESOP) might be a worthwhile approach. For further professional support in moving forward with a plan like this, consider consulting a financial advisor.

Employee Stock Ownership Plan (ESOP) Definition

An employee stock ownership plan is a benefit plan for employees that gives them ownership interest in that company who they work for. A plan like this is normally formed to let employees take the opportunity to buy stock in the company. ESOPs are fundamentally retirement plans, and are subject to some of the same laws and regulations as 401(k) plans. However, they offer certain advantages or benefits to the companies, owners and employees.

How Does an ESOP Work?

An ESOP is similar to a profit-sharing plan. It basically acquires company stock and holds it in accounts for employees. First, the company sets up a trust fund and contributes new shares of its own stock, or cash to buy existing shares, into the fund. As an alternative, the ESOP can borrow money to buy these new or existing shares. The price of the shares are determined by an independent appraisal.

The company can make cash contributions to the plan in order to repay the loan. Company contributions to the trust are tax-deductible, but there are specific limits (relative to its EBITDA) within which the company must go through with these.

Then, the shares that are in the trust are then allocated to individual employee accounts. There are rules and laws to make sure that allocations are made fairly, such as on the basis of relative pay.

When employees leave the company or retire, they receive the stock. They do not pay taxes on the contributions until that time. The now former employee either sells the stock on market or sells it back to the company.

Uses and Benefits of ESOPs

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ESOPs can be particularly beneficial for companies, with stock and cash contributions being tax-deductible for them. Uses of the plans include buying the shares of a departing owner, borrowing money at a lower after-tax cost and creating an additional employee benefit.

In general, these plans provide an incentive for employees to want to see the company’s stock perform well – and approach their work and ethos at the company in such a way that this is more likely to happen. They can also help boost employee savings for things like short-term financial goals or emergency funds, or long-term retirement funds.

Other Forms of Employee Ownership

Besides ESOPs, there are other forms of employee ownership. Some of these are stock options, restricted stock, phantom stock, stock appreciation rates and direct-purchase programs.

Stock options are contracts that give an employee the right to buy or exercise specific number of shares of company stock at a preset price (grant price). Restricted stock options are similar, but there is no stock pricing involved, and the company commits to giving an employee stock in the company when a specific requirement is fulfilled by the employee. Phantom stock is available for senior employees at some companies and gives these employees some of the financial benefits of owning shares without actually giving them company stock. Stock appreciation rights also do not require employees to actually buy stock in order to receive proceeds from stock price increases. A direct-purchase plan allows individual to buy stocks directly from a company rather than through a brokerage.

Bottom Line

Image shows the hands of two people sitting next to each other; they are holding financial documents and a calculator while they complete some calculations about their employee stock ownership plan.

Employee stock ownership plans (ESOPs) can be an efficient and encouraging way to allow employees to reap the benefits of their hard work and to continue to stay invested in a company. They can also help employees increase savings and retirement funds. To create one, a company will need to first set up a trust fund from which workers can buy stock from the company.

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