An ESOP is an employee benefit plan offering workers ownership stakes in a business organization. The workers will allocate a particular percentage of the organization’s share to every eligible worker without an upfront cost.

The share distribution depends on workers’ terms of service, pay scale, and other allocation bases. Usually, shares for employee stock ownership plan are held in trust units for growth and safety until workers retire or leave the organization.

Business organizations with many employee-ownerships are called employee-owned corporations and are the same as worker cooperatives.

The only difference between ESOP and worker corporative is that with employee stock ownership plans, the capital of a company will not be distributed evenly.

Plus, senior workers are allocated more stocks than newly hired employees. And thus, the latter exercises less voting power at the shareholder meetings.

How ESOP Works

An employee stock ownership plan is normally formed to facilitate succession planning in closely held companies by offering workers a chance to purchase shares of corporate stocks. ESOP is set as a trust fund, and companies may fund them by putting newly issued shares to them and investing money so as to purchase existing shares of the company. Business organizations of every size use ESOP, and that includes a couple of publicly traded corporations.

In contrast to what some individuals say, business organizations with ESOP shouldn’t discriminate and are needed to appoint trustees to act as plan fiduciary. Among other things, it will not be possible for ESOP participants to have no rights to vote or for a senior worker to get more shares.

Forms of Employee Stock Ownership Plan

Various forms of ESOP differ based on your organization’s size, the reason for introducing the plan, and the number of workers in the business. The most common types of ESOPs include:

  • Issuance
  • Leveraged
  • Unleveraged

Rules of ESOPs

In ESOPs, a business organization may set up trust funds into which it contributes shares of its stock or money to buy the existing shares.

Alternatively, ESOPs may borrow cash to purchase existing or new shares, with a business organization making money contributions to enable it to repay loans.

No matter how ESOP gets stocks, a company’s contribution to the trust is tax-deductible, within a particular limit.

The tax bill in 2017 limits a net interest deduction for a business to around 30% of EBITDA for four years. In simple words, in 2022, businesses can subtract amortization and depreciation from their earnings before they calculate the maximum deductible interest payment.

According to BoardRoom, when workers leave the business organization, they will get their shares, which the company should buy from them at a fair market value.

Private organizations need to have annual outside valuations so as to determine the cost of their shares. In a private organization, workers should vote on their allocated stocks on main issues, like relocating or closing. Though the organization may choose whether or not to pass through voting rights.

Main Uses of ESOP

More than two-thirds of employee stock ownership plans are used to offer a market for every departing owner. Most are used to borrow cash in a tax-favored manner or as a supplemental employee benefit plan.

No more than 10% of plans are in public business organizations. But stock options or other compensation plans are primarily used in growing private organizations and as employee benefits in public companies.

ESOPS may as well be used for incentive purposes. The business organization can buy vested shares from resigning or retiring workers at the point of resignation or retirement.

How Long it Will Take to Get Your ESOP Shares

Workers should start distributions after a particular time, outlined in a planning agreement that the employee signed. Though there are exceptions.

One important thing to keep in mind is that ESOP is a qualified retirement plan and is subject to about a 10% penalty when you touch the cash before 59 years and a half of age. But a dividend passed through ESOPs is not subject to that penalty tax.

Workers who have passed away, become disabled, or have reached the normal retirement age plan, which is not later than 65 years, should receive their payment from employee stake ownership plans during their plan year.

Another exception is that workers who are fired or quit should start receiving distributions no later than about five years after the year they left the company.

Most of the time, organizations may allow workers who got terminated to start distributions at the age of 55 years. And they might do so without penalty taxes. In rare situations, ESOP will allow workers to borrow money against their plans, as 401(k) at times allows.

Are ESOPs Worthwhile?

For a job candidate interviewing a business organization with an ESOP or receiving a job offer, it is imperative to pay attention to the implications. As with every benefit, you must consider this and the salary when reviewing offers if the organization is a perfect fit for you.

If a business organization doesn’t provide additional retirement benefits, like a 401(k) plan, and you are worried about the organization’s overall health, ESOPs might not be helpful due to the risks you take when the performance of the company goes south.

However, ESOPs can attract employee retention and top talent. Mostly, workers who work in a company for less than two years at an organization may forfeit their stocks. A worker serving for four years may get about 40% of their shares upon leaving.

This process of vesting should work with a business organization to receive a share payout or motivate workers to stay with the company for a long time. Having a chance to have shares in an organization might be a bonus for talented workers looking to seek new work opportunities. Apart from this, ESOPs can also guarantee you the following:

  • No change in governance
  • Tax benefits
  • Increased productivity

The Takeaway!

An ESOP remains a mechanism, which facilitates employee ownership in a business organization. So when broadening workers’ ownership, ESOPs might be a helpful policy instrument to raise cash for the company, improve enterprise performance, and promote privatization.