What is an ESOP?
An ESOP (Employee Stock Ownership Plan) is a Defined Contribution retirement plan governed by the Employee Retirement Income Security Act of 1974 (ERISA). ESOPs are often established to create a market for private or closely held companies.
How are contributions made to an ESOP?
Contributions can be made to the plan in cash or in shares of employer stock. Contributions are allocated to participants as a percentage of their eligible compensation. When starting an ESOP, the plan can be designed so that all employees receive an allocation of the same percentage, or the company can be divided into groups with a different allocation to each group (tiered allocation formula).
Since an ESOP is a Defined Contribution plan, contributions are discretionary and determined by the Employer from year to year just like a Profit Sharing plan.
How does the ESOP buy stock from an existing shareholder?
Cash (non-leveraged) transaction:
Leveraged transaction:
Are there special tax deduction rules available for ESOPs?
Tax benefits to utilizing an ESOP can be significant!
Are there special tax advantages available for the selling shareholder?
If the existing shareholder sells at least 30% of the outstanding shares of the corporation to the ESOP, the shareholder may elect a §1042 exchange. Under a §1042 exchange, the selling shareholder is not taxed of gain of the stock if:
How is the value of the shares determined?
A valuation must be performed by an independent appraiser to determine the Fair Market Value of the stock. A valuation must be performed at the following times:
How do participants receive distributions from the ESOP?
As with most retirement plans, distributions are processed upon “triggering” events:
Participants must be given the option of taking their distribution in shares of stock, but typically they sell their shares back to the plan or to the corporation. This is called a “put” option. Since the repurchase of shares from departing plan participants might cause a cash-flow crisis, distributions may be delayed for a year or more after termination, and/or paid over time.
SUMMARY
ESOPs offer a unique tax advantaged way to transition ownership from an existing shareholder to the employees of a company. The existing shareholder may remain an active member of the company and even continue to manage the firm after the transaction. When starting an ESOP, it is important to work with advisors who have only your best interest at heart. If you have questions that move beyond the ESOP FAQs give us a call, we'd be happy to help.