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ESOP Pros and Cons – What You Didn’t Know!

Employee Stock Ownership Plans (ESOP) has seen a great expansion since they were started in 1974. There are many reasons to choose an ESOP. Let’s explore the ESOP pros and cons.

For company employees and management, ESOP participation can be an incentive for the dedication and hard work, as well as for future business growth.

What is an ESOP?

ESOP is defined as an Employee Stock Ownership Plan. The benefit of an ESOP is to allow employees to acquire beneficial ownership in their company without having to invest their own money. A tax-exempt Trust oversees the Plan, referred to as ESOT, Employee Stock Ownership Trust.  

For this reason, the plan is also called the ESOT. It is a tax-exempt entity for Federal and state corporate income tax purposes. An ESOP allows the company to make cash and company stock contributions to the Trust and use it to purchase stocks in the company on behalf of its employees. 

The benefit is that employees can obtain this stock without paying a current income tax. Again, this allows contributions to be made entirely by the company and is not taxed to employees since it is designated. One significant advantage to the company is that the ESOP makes pre-tax dollars available to fund company growth and to create ownership liquidity at the time of retirement. Keep reading to find out more about ESOP pros and cons.

ESOP Pros and Cons

Exit Strategy 

Today, many private companies use ESOPs as their exit strategy. These plans are great tools for succession plans and liquidity and transition. Additionally, to various tax benefits, ESOPs also allows business owners to reward their employees and managers with a stake in the business.

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Flexible and Friendly Transactions 

The flexibility of ESOP transactions allows a business owner to withdraw funds slowly or take a lump sum at once, which depends on their personal needs. A business owner can sell from one to 100 percent of their stock to the newly created ESOP. The owner can remain active in the business even after selling all or most of the company.

Continuity of Governance

Members of management retain their company positions, and it allows for smooth changes when an ESOP is started. Shareholder confidence in the company’s ability to grow the business is critical to creating available resources to pay off additional debt. Another advantage of a smooth change is that long-term supplier, distributor, and customer relationships remain uninterrupted.

Employee Ownership means Employee Benefits

Being a member of an ESOP company provides significant incentives for employees. Business owners in the plan can receive significant retirement benefits at no monetary cost to them. Research shows ESOP companies are more productive, faster-growing, receive more profits and have a much lower loss of benefits that accrue to all stakeholders, including the retirement accounts of the employee-owners. Also, an ESOP is a great way to enhance the company’s ability to recruit and retain top talent. Active and ongoing employee communications to encourage employees to think and act like owners are necessary to generate these benefits.

Tax Advantages 

The tax advantages associated with ESOPs can be significant for the selling shareholders and the company. Dividends are tax-deductible in ESOP plans. The more significant tax advantage is to the corporation. ESOP payments are made to satisfy the debt incurred as part of the transaction. The payments made to a financial institution or selling shareholder provide a tax deduction to the corporation.

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Cons of Employee Stock Ownership Plans (ESOPs)

May not be a Good Fit for Every Company

A great contender for an ESOP must have strong management teams and generally produce consistent and predictable financial results. Also, keep in mind these plans correspond with shareholders who sell their stock and want to preserve the legacy of the corporation. While ESOP incentives are competitively priced, the ESOP cannot pay a strategic premium for the shares it receives.

Long Term Plans for the Sustainability

Long term plans for the sustainability of the ESOP and company are one of the most important cogitations when implementing an ESOP. The companies can repurchase vested shares from their ESOP members who leave employment. Careful resource planning should take into account the funds necessary to meet ESOP repurchase obligations. 

Proper Management and Operation of the Business

The ESOP only provides benefits to the participants if the underlying shares are determined to have value. Therefore, proper management and operation of the business are critical to creating a successful ESOP company. An ESOP that fails can lead to job loss for employees as well as any value that may have occurred in their ESOP accounts. For this reason, it is widely recommended that companies offer retirement benefits in addition to the ESOP. A large percentage of companies that have an ESOP also maintain a 401(k) or profit-sharing plan.

Why ESOPs are Popular

ESOPs are an increasingly popular method of moving business ownership. An important part of ESOP creation includes plans that allow key employees to stay focused and inclined to stay with and grow the company by rewarding them for good performances. This creates a dual advantage: For key employees, it gives an incentive for staying with and growing the corporation as the owners get ready to leave. For owners, it builds their companies’ exchangeable value, which makes it easier for them to exit on their terms.

What are the Benefits of an ESOP?

Below you will find some of the top benefits of an ESOP.

  • Liquidity and Diversification for Seller – Selling all or part of the corporation to an employee stock ownership plan (ESOP) offers business owners liquidity and diversification. It also decreases the investment risk of having all their wealth in one held investment and permits the business owner to create a more diversified portfolio. If preferred, all of this can be completed while retaining control of the company.
  • Increase Employee Productivity – ESOP’s improved employee incentives helps to increase productivity and motivation.
  • Increase Company Cash Flow Business Succession Tool – when the company’s on-going income tax obligation is removed.
  • ESOP Versus Other Liquidity Alternatives – A suitably structured ESOP can deliver liquidity for a portion of business owners’ shares at a fair price. That reasonable price is a fair market value as determined by an independent appraisal and that won’t be a strategic price and won’t reflect potential synergies.

Participating in a company’s ESOP is taking a proactive step towards retirement.  Do you have any other ESOP pros and cons not mentioned in the above article? Please share your comments below. In addition, if you would like to learn more about M&A Advisory Services, check out our blog or our merger and acquisitions page.

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FAQ of ESOP

Is an ESOP a good idea? 

ESOPS are a good idea for many reasons.  An ESOP is a non-taxable trust. Employers can donate shares or cash for employees to buy shares based on a formal plan. The non-tax part is very good: employees don’t get taxed on the donations and employers get a tax deduction.

What are the advantages of ESOP?  

Advantages to an ESOP include an Exit Strategy for a company. It offers a flexible and friendly transaction as well as tax advantages.

Are ESOP plans good for employees? 

Being part of an ESOP company can make available significant rewards for their employees. ESOP members in the plan can receive tremendous retirement benefits at no monetary cost to them. Also, an ESOP is a great way to improve the company’s ability to recruit and retain key employees.

How ESOP is taxed?  

ESOP participants pay no tax on stock assigned to their ESOP accounts until they receive distributions, then they are taxed on the distributions.  If the money is rolled over into an IRA or another plan, the employee pays no tax until the money is withdrawn, at that time, it is taxed as ordinary income.

Is an ESOP a good idea?  

They are a good idea for many reasons. An ESOP is a non-taxable trust. Employers can donate shares or cash for employees to buy shares based on the ESOP  plan guidelines. The non-tax part is very good because employees don’t get taxed on the contributions and employers get a tax deduction.

Are ESOP plans good for employees? 

Being a  part of an ESOP company can create significant rewards for employees. ESOP members in the plan can receive tremendous retirement benefits at no monetary cost to them. Also, an ESOP is a great way to improve the company’s ability to recruit and retain key employees.

How ESOP is taxed? 

ESOP participants pay no tax on stock assigned to their ESOP accounts until they receive distributions, then they will be taxed on the distributions. If the money is rolled over into an IRA or another plan, the employee pays no tax until the money is withdrawn, at that time, it is taxed as regular income.

What is ESOP in salary? 

An ESOP is a defined contribution employee benefit plan that permits employees to become owners of stock in the corporation. It is an equity-based delayed compensation plan. Several features make ESOPs different from other employee benefit plans.

What happens to your ESOP when you quit? If you quit or are laid off, the ESOP distributions are postponed for six years under IRS regulations. Once those six years pass, you can get the value of your ESOP shares in either one lump sum, or equal payouts made over five years.

How is ESOP calculated?  

The value of the ESOP (on date of allocation) = (Fair Market Value per share – Exercise price per share) x number of shares allotted. The amount calculated above is the value of  the ESOP

Can I use my ESOP to buy a house?   

Yes, the IRS allows a person to take a loan from their ESOP account for any reason, however, an employer holds the right to permit a loan only for specific purposes, such as to pay for college expenses or the purchase of a home, as long as the restrictions apply to all of the ESOP’s participants.

What does ESOP mean to employees?  

An employee stock ownership plan (ESOP) is an employee benefit plan that gives the employee ownership interest in the company. ESOPs gives the company, the selling shareholder, and participants different tax benefits.

Can you cash out ESOP?   

Yes, employees may cash out from an ESOP plan based on the ESOP plan guidelines. The participant may fill out the forms to take either a lump-sum distribution or receive periodic payments from the ESOP plan, federal taxes will be withheld from these payments.

Does an ESOP pay taxes? 

The company makes annual tax-free contributions to each employee’s ESOP account. An ESOP is a tax-exempt trust set up for the benefit of employees. Similar to a 401(k), the employee will pay taxes when they in due course cash out their shares of the ESOP—which can grow to impressive numbers.

Do ESOPs pay dividends?  

For many employee ownership companies, the answer is yes. Dividends from ESOP shares are paid directly to employees, with the company deducting their value. Dividends that are reinvested by employees in company stock are also tax-deductible.

Is ESOP a retirement plan? 

An employee stock ownership plan (ESOP) is an IRS qualified retirement plan, comparable to a 401(K) Plan, that buys, holds, sells company stock, it provides employees with stock ownership in the company, as well as other forms of compensation linked to the success of the company.

Can I take money out of my ESOP? 

Yes, employees may cash out from an ESOP plan based on the ESOP plan guidelines. The participant may fill out the forms to take either a lump-sum distribution or receive periodic payments from the ESOP plan, federal taxes will be withheld from these payments.

Is an ESOP a profit-sharing plan? 

Profit-sharing plans are considered as employee benefit plans. The ESOP is primarily regarded as a “tool of corporate finance,” according to IRS rulings and regulations. Hence, ESOPs are permitted under profit-sharing plans.

Why is ESOP given? 

An employee stock ownership plan gives workers ownership interest in their corporation. ESOP is created to allow employees the chance to buy stock in a closely held company to enable succession planning.

Is ESOP part of CTC? 

Employee stock options (ESOPs) is one of the sections of the CTC which permits the employees to buy a predefined number of shares or equity stake in their corporation at a fixed market price. ESOPs starts to form the overall CTC. ESOPs allow ownership in the company which is offered by the company itself.

When can you cash out ESOP?  

At the age of 59-½, you can withdraw the funds and avoid the penalty however, the distribution is taxed at income tax rates.

What happens when an ESOP goes public? 

If they go public, the effect on the ESOP participants is that the shares that they currently have, are now converted to shares at publicly traded prices. Under the distribution rules of the ESOP, if you terminate your employment with the company before age 62, you are unable to receive any buyouts until at least age 62.

How do you explain vesting?  

Vesting refers to the ownership of your ESOP.

 What is the fair market value of a stock? 

Fair market value is the accepted current value of one share of a private corporation’s common stock. It represents what the stock would be worth on the open market. But, this is not the same thing as “post-money valuation”, which is the market value for the entire company.

How do you invest in ESOP?  

In an ESOP, a company sets up a trust fund, into which it donates new shares of its stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash donations to the plan to enable it to repay the loan.

Can I roll my ESOP into an IRA?  

Yes, rollovers from ESOP distributions to IRAs are available for distributions of stock or payments over periods of less than 10 years. As with other tax-qualified retirement plans, an ESOP distribution can be rolled over into a “traditional” (regular) IRA or a Roth IRA.

Can I roll my ESOP into a 401k?  

Typically, you would have your ESOP shares rolled over into the shares of the new company ESOP. In other cases, the acquiring company will cash out your shares and roll the proceeds into an account in your name in a 401(k) plan.

What is the purpose of ESOP?  

The purpose of an ESOP is an employee benefit plan, similar in some ways to a profit-sharing plan. The company sets up a trust fund, into which it gives new shares of its stock or cash to buy existing shares. Shares in the trust are apportioned to individual employee accounts.

What does an ESOP mean to me? 

ESOP stands for “Employee Stock Ownership Plan.” However, to me, being part of an ESOP is more than sharing ownership with your co-workers. Being part of an ESOP means having partial control in the company. It also means taking control of my retirement.

4 replies on “ESOP Pros and Cons – What You Didn’t Know!”

I bought some shares in the company I’ve been working for as a part of my retirement plan. Our financial advisor said it could help us reach our goals in addition to our 401k. We are getting close to retirement age and I’m increasingly grateful for our 401k and our company shares the closer we get to actually retiring.

I’ve done some research on ESOPs and it turns out that not only do they increase the company cash flow and employee productivity, they do a lot more. Did you know that the productivity rate increases by more than 50 percent after a company implements and ESOP plan? The GAO studies from the late 80s confirm this.

I have to say, I am often curious about ESOP plans so I enjoyed reading your article. I decided not to participate in my company ESOP. For one thing, I didn’t want to pay for the shares at cost. Then, my financial advisor recommended an index fund.

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