How an ESOP Works

• Aug 02, 2019

An Overview of the Employee Benefit Plan

An ESOP is a type of employee benefit plan that benefits the employer and the employees.

Through tax-deductible contributions, employees enjoy additional perks while employers benefit from increased motivation and morale.

To explore these advantages, you should know how an ESOP works.

What Is an ESOP?

With an employee stock ownership plan (ESOP), employees receive an ownership interest in a company.

The employer establishes a trust fund and contributes to it with either newly issued shares or cash to buy existing shares. In some cases, companies borrow funds through third parties to buy shares, providing a source for fast cash.
The ESOP gives employees more interest in the performance of the shares. As shareholders, employees have more motivation for the company to succeed.

When an employee retires or departs the company, the company purchases vested shares and the employee receives cash. The payments are either provided in a lump sum or periodic payments.

Non-Leveraged vs. Leveraged ESOPs
To understand how an ESOP works, compare non-leveraged and leverages plans. With a non-leveraged ESOP, companies make tax-deductible contributions of cash or shares to the ESOP fund. This gives employees equity ownership in the organization.

A leveraged ESOP gives tax advantages for generating capital or purchasing acquired stocks. Instead of funding the ESOP with cash or shares from the company, the company borrows from a lender. The company leverages the loan to inject funds into the company through newly issued shares.

Advantages of Establishing an ESOP

Everyone involved benefits from the ESOP, including the employees, shareholders, and employers.
Through an ESOP, employees receive additional tax-free assets toward their retirement. The IRS only taxes the income earned when employees receive their distributions.

Shareholders also benefit, thanks to the increased liquidity of stock in the privately held company. When shareholders need to sell quickly, an ESOP helps ensure fast cash. This prevents shareholders from dealing with the penalties of deferred payment.
Employers get to contribute tax-deductible funds to the ESOP. The tax advantages of this employee benefit plan provide greater flexibility, including the ability to aid corporate financing. For example, a business may use the ESOP to refinance the debt or raise equity.
These are just a few examples of how an ESOP works and the reasons for implementing one in your organization. Before establishing an ESOP, businesses should review the details of the plan to ensure compliance with IRS and Department of Labor regulations.