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What Is an Employee Stock Ownership Plan (ESOP)?

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What Is an Employee Stock Ownership Plan (ESOP)? HNW_NRG_C_Inset_Mask What is an employee stock ownership plan (ESOP)? An employee stock ownership plan (ESOP) is a qualifi ed retirement plan that provides tax advantages to both the employer and employees. Similar to a traditional profi t-sharing plan, an ESOP offers many additional advantages. Benefi ts for the employer either cash or shares of company participants and control over ESOPs provide a unique way for stock to the trust on behalf $900 billion in plan assets. ESOP business owners to diversify their of participating employees. If legislation continues to provide risk on a tax-advantaged basis. They employers make cash contributions, incentives and advantages to allow business owners to cash out the trust uses that money to both companies and employees, some or all of their equity in the purchase shares of company adding to the attractiveness company while keeping operational stock either from shareholders of this liquidity option.* or from the company itself. control. Closely held business Because of the broad appeal of these owners can use an ESOP as an An ESOP is an excellent way to plans, ESOP candidates can vary excellent estate-planning tool that reward employees with retirement widely. Most ESOPs (approximately generates liquidity for their shares benefi ts at no cost to them while 97 percent) are established for and creates succession options for inspiring them to participate in the privately held companies.* Any those involved in the business. growth and success of the company. company—whether a manufacturing, Designed to invest mainly in the Because ESOPs have many tax distribution or service business— stock of the employer, an ESOP advantages, employees do not pay that can borrow enough money to can be a stock bonus plan or a tax on the stock allocation to their fund the ESOP is a viable candidate. combination stock bonus plan and accounts until distributions are However, high-end service businesses money purchase pension plan. The taken, usually after retirement. with educated workforces— such Internal Revenue Code (IRC) gives as architecture, engineering or consulting fi rms—tend to be better tax incentives to employers who sell Who qualifi es for an ESOP? represented in ESOPs today. their company stock to the ESOP. A growing trend Companies can benefi t from tax savings in many ways using this ESOPs have existed for many years. The potential ESOP candidate The concept was fi rst developed unique corporate fi nancing strategy. While each situation is different, in the 1950s and legislation here are some characteristics of implementing tax advantages Benefi ts for the employee a possible ESOP candidate: for ESOPs was passed in 1974. A unique aspect of ESOPs is that While there was only a handful • The company must currently be a benefi ts are paid to participating in the 1970s, today there are C corp, or a Sub S, or the business employees in the form of company more than 11,000 ESOP plans.* owner must be willing to convert. stock. A trust fi duciary sets up individual accounts within the trust The National Center for Employee • The company must have for each participating employee. Ownership (NCEO) estimates suffi cient collateral or cash The employer then contributes that ESOPs have 13.7 million plan fl ow to support funded debt. Investment and insurance products offered through RBC Wealth Management are not insured by the FDIC or any other federal government agency, are not deposits or other obligations of, or guaranteed by, a bank or any bank affi liate, and are subject to investment risks, including possible loss of the principal amount invested. Page 2 of 2 What is an employee stock ownership plan (ESOP)?, continued • A successor management of businesses in the U.S., will be of the business needs to be sold to team should be in place or changing ownership as a result. the ESOP to obtain these tax benefits, developed over time. ESOPs offer important benefits to while the owner can continue to help company owners make this participate in their business. • The company should have been transition. These benefits make in business for several years Tax benefits of an ESOP produce ESOPs an excellent alternative and be experiencing steady financial rewards not just for the to other exit strategies. They can and controlled growth. company but also for the owner and facilitate family business succession the employees. As the employer • The company should have had planning and estate planning through sponsoring an ESOP for your strong earnings and cash flow over the transfer of different types of employees, your contributions to the the previous two years and be assets to family members with plan—in the form of company stock able to reasonably predict future different levels of involvement. And or cash used to purchase company revenue and cash flows (probably because ESOPs can be structured stock—are generally tax-deductible more important than having hard as a series of transactions, they on your federal income return for assets to support the loan). can be either an intermediate the year in which you make those or long-term exit strategy. • The selling shareholders contributions. To be eligible for this should want to participate employer tax benefit, your plan in the future growth of the Tax advantages must remain a “qualified” plan. company after the sale. The tax code gives sellers the ability to defer capital gains tax while giving Exit strategies the company tax deductions. ESOPs are tax exempt and pay no tax on Baby boomers are retiring rapidly their pro-rata share of company these days, and over the next decade, earnings. In addition, only 30 percent approximately 30 to 40 percent How ESOPs work The following steps illustrate the way most companies establish an ESOP When employees retire or leave the company, they receive a distribution of their vested benefits in the form of cash or company stock. If in stock, the employee can choose to either A company borrows hold the stock or sell it back to the company money to finance the at fair market value. If the stock is not publicly 1 purchase of stock from traded, the employee must have the right to sell 7 current shareholders. the stock to the company at fair market value. 2 3 4 5 6 The company then A trust is created The company The trust uses After time, employees lends these funds to buy stock of makes annual the cash to pay are vested based on to the ESOP. the company on cash contributions down the ESOP years of service for behalf of the from its operating loan while a trust the shares in ESOP plan. profits to the trust fiduciary releases their account. (which are and allocates tax deductible). shares of the company’s stock to the accounts of plan participants (employees) according to a pre-established formula. *National Center for Employee Ownership (NCEO) The material contained herein is for informational purposes only and does not constitute tax advice. Investors should consult with their own tax advisor or attorney with regard to their personal tax situation. © 2020 RBC Wealth Management, a division of RBC Capital Markets, LLC, Member NYSE/FINRA/SIPC. All rights reserved. 20-37-04018_3755 (12/20).
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