ESOPs for Small Corporations

Article written by EricBank

If you run a small or closely held corporation, you can compensate employees just like the big boys do by setting up an employee stock ownership plan. This is a great way to build employee loyalty without indulging in expensive cash bonuses or raises. An ESOP is one of several ways for employees to receive stock shares from their employers. Other methods include stock options, bonuses, direct purchase and profit-sharing plans. As of 2014, about 7,000 U.S. companies sponsored ESOPs, covering 13.5 million employees and making it the nation's most common type of employee ownership. ESOP's have a number of benefits, but can be expensive to set up and have a few other drawbacks.

Setting up an ESOP

Usually, corporations give, rather than sell, ESOP shares to employees. Regulations require the company to create a trust fund to administer the ESOP. The company can contribute cash or shares to the trust directly, or the trust can borrow money to buy the company's shares and then receive reimbursement from the company. The company takes a tax deduction for contributions to the ESOP. In public companies, ESOP shares give employees full voting rights. However, private companies might limit employee voting rights to only major issues, such as a plant closing.

How ESOPs Work

Each employee in the plan has an individual account that receives shares from the trust. Normally, all full-time employees above age 21 can join the ESOP. Some metric, such as salary and/or seniority, determine each employee's share allocation. Share ownership is "vested" -- employees must remain with the company for a specified number of years, usually between three and six, to gain full ownership of their ESOP shares. Upon separating from the company, the employee takes the vested shares, if publicly traded, or receives the stock's fair market value from the company.

Uses of ESOPs

Frequently, closely held companies set up ESOPs to buy shares from departing owners as a reward for service. An ESOP provides a way to create additional employee benefits and thereby foster loyalty. ESOPs also offer several tax benefits. Corporate contributions of cash or stock to the ESOP are tax-deductible, and when an ESOP trust borrows money to buy shares, the corporation can deduct the reimbursement to the trust of principal and interest. The corporation can deduct the cost of dividends paid on ESOP shares. Employees may qualify for certain tax deferrals when selling ESOP shares and can roll the shares into an individual retirement account tax-free.

ESOP Cautions

Even the simplest ESOP can cost about $40,000 to establish, which might be unacceptably high for a small company. Regulations do not permit professional corporations and partnerships to use ESOPs. S corporations can establish ESOPs but are subject to lower contribution limits. A private company must buy back vested ESOP shares from departing employees, which can be a significant expense, especially in a mass resignation or layoff. Another drawback of ESOPs is that the shares issued to employees dilute the holdings of other shareowners.