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ESOP Frequently Asked Questions

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What is an ESOP?

An ESOP is a combination of a stock bonus plan, which is designed to pay benefits in the form of company stock, and a money purchase pension plan, which commits the company to a minimum annual contribution. An ESOP is a plan designed to invest primarily in employer stock for the benefit of the employees. It also can provide various tax benefits to the sponsor.

How do ESOPs work?

To set up an ESOP, a company creates a trust fund for employees and funds it by one of the following methods:
  • Contributing company shares.
  • Contributing cash to buy company shares.
  • Having the plan borrow money to buy shares and then making payments to the ESOP trust to repay the loan.
The shares are held in the trust under separate personal accounts for each participating employee. The employees receive the stock or a cash equivalent when they leave the company.

How can an ESOP benefit my company?

There are a number of advantages to having an ESOP. With an ESOP, a closely-held company can borrow money to purchase company stock with pretax dollars from shareholders who want to sell.
  • ESOPs can also be used to purchase shares from owners of closely-held companies who wish to sell but also want to defer the capital gains from the sale. This also assures the owner of passing on ownership to "known entities" and provides a smooth transition for all concerned.
  • Funds borrowed by an ESOP can be used to repurchase shares in public companies. Proceeds from the sale can then be used for a variety of business purposes, such as purchasing new equipment, buying another business, or refinancing debt.
  • An ESOP is a way for a company to give employees an additional tax- deferred benefit and also allows them to share in the growth of their company, which can result in higher employee satisfaction and productivity.

What are the tax advantages of an ESOP?

In addition to the fact that employees participating in an ESOP are not taxed on stock allocated to their accounts until they receive distributions, there are also three significant tax advantages for corporations and selling shareholders.
  • The employer can deduct contributions to the ESOP, including both principal and interest on loans the ESOP uses to purchase company stock. ESOPs also have higher contribution and deduction limits than are normally available for defined contribution plans where the employer contribution is discretionary.
  • The employer generally can deduct reasonable cash dividends on ESOP-held stock if the dividends are paid to the ESOP and are then used to repay an ESOP loan or passed through to participants.
  • The owner of a closely-held company can defer taxation on his or her gains from the sale of company stock to the ESOP, provided the ESOP owns 30% or more of the company’s shares after the sale. However, the sale proceeds must be reinvested in stocks, bonds or other securities of U.S. operating companies.

Are there different types of ESOPs?

There are two types of ESOPs, leveraged and non-leveraged. Additionally, ESOPs may be combined with or converted from other employee benefit plans.
A Non-Leveraged ESOP is a stock bonus plan that invests primarily in company stock. The sponsoring employer contributes newly issued or treasury stock and/or cash to buy stock from existing owners. Contributions generally may equal up to 15% of the combined payroll of all eligible employees, or up to 25% if combined with a money purchase plan.
A Leveraged ESOP borrows money to buy company stock. It is the only qualified employee benefit plan that can do this. The purchased shares are placed in a "suspense account;" then, as the loan is repaid, the shares are gradually released and allocated to participants' accounts.

How do I know if an ESOP is right for my company?

There are a few requirements and conditions that you should consider in making this decision.
  • Your company must be or convert to a C corporation or an S corporation.
  • Your corporate culture should be suited to, or adaptable to, employee ownership. Both managers and non-management employees must be amenable to the idea.
  • An ESOP may be too expensive if your company is too small. A rule of thumb is that ESOPs work best for companies that are in the top corporate tax bracket with at least 20 employees and over $250,000 in payroll.
  • If you want to buy out an owner's interest through a leveraged ESOP, it may be impractical if your covered payroll is too small relative to the value of the owner's interest.
  • An ESOP can be unrealistic for many startup companies. The costs of an ESOP may outweigh the benefits if the company is not yet profitable and has no taxes on which to take ESOP deductions. The owners may also be unwilling to sell their stock or issue new stock.

Is my existing lending relationship a potential source?

It is always a possibility that you can take advantage of an existing lending relationship. However, it’s also important to keep in mind that the economic and legal nuances of ESOPs often require a lender experienced in this area. An ESOP lender should also have a thorough understanding and appreciation of a company's cash flow as well as its assets, and be willing to consider the loan based on both of these aspects.

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