What Is an ESOP?

An employee stock ownership plan 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, making it the nation's most common type of employee ownership. ESOP's have a number of benefits worth noting.

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 criteria, such as salary and/or seniority, determine each employee's share allocation. Share ownership is "vested," meaning 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 leaving 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

When the founder of a private company retires, the company may use an ESOP to buy the founder's shares. In this way, the founder receives a large amount of cash. An ESOP provides a way to create additional employee benefits and thereby encourage loyalty. ESOPs also offer several tax benefits to employees. For example, employees owe no additional taxes when shares are contributed to their ESOP accounts. In addition, employees may be able to delay paying income taxes when selling ESOP shares and can roll the shares into an individual retirement account tax-free.

ESOPs for S Corporations

If you are self-employed, you might operate as an "S corporation." With this setup, you treat any profits made by the corporation as your own personal income and you pay only personal income taxes, not corporate income taxes, on those profits. If you create an ESOP to hold all of the shares of the S corporation, you don't have to pay any federal income taxes -- corporate or individual -- on the corporation's profits. However, you must pay personal income taxes on any money you withdraw from the corporation.

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