ESOP: Understanding Employee Stock Ownership Plans - Benefits & How They Work

An employee stock ownership plan or ESOP is a type of benefit plan that businesses can set up for their employees in order to provide them with stock. This type of plan has several unique features when it comes to providing a benefit plan for your employees. This plan can borrow money and can assist employees gain additional ownership share in their company.

Employee Stock Ownership Plan

With an employee stock ownership plan, a company sets up a trust arrangement. The company then puts shares of its own stock into the trust. It could also put cash into the trust with the purpose of buying shares of stock. Once the shares are in the trust, they are then allocated to individual employee accounts. In most cases every employee in the company that is over the age of 21 will receive some shares of stock. Generally, the shares of stock are distributed according to some formula. They might give more shares to those that have been with the company longer or to those that hold higher positions in the company. Periodically, the company will put more shares of stock into the employee stock ownership plan so that employees can continue to accumulate ownership in the company.

Vesting

As these shares accumulate in the employee accounts, they do not necessarily have access to them right away. Each employee must go through a process known as vesting. With vesting, the employee receives the rights to a certain percentage of the shares every year. For example, they might get 20% of the shares after one year of service and 40% after 2 years. Regardless of the vesting schedule, they have to be fully vested within 6 years of getting into the program. At that point, if they leave the company, they can take 100% of the shares that they have accumulated in the company. This program is designed to retain employees for as long as possible. If they leave too soon, they will forfeit the rights to the stock that they have accumulated.

Borrowing Money

One of the unique features of the employee stock ownership plan is that it can borrow money. With this type of trust arrangement, the trust can actually borrow money in order to buy additional stock for the employees. The owner of the business can then put cash into the trust in order to pay back the loan. The contributions that are made into the trust are tax-deductible. This means that a business could potentially take out a loan with the trust and then make fully tax-deductible payments to the trust in order to repay the loan. If the business were to take out a loan independently, they would only be able to deduct the amount of interest that they pay on the loan. With this arrangement, they essentially get to deduct both the principal and the interest that is paid on the loan. This provides them with an additional tax incentive.