Significant Benefits and Advantages of Employee Stock Option Plan
Employee Stock Option Plan
ESOPs Provide a Variety of Significant Tax Benefits for Companies and Their Owners.
ESOP Rules Are Designed to Assure the Plans Benefit Employees Fairly and Broadly. But by far the most common form of employee ownership in the U.S. is the ESOP, or employee stock ownership plan.
Definition: An Employee Stock Option Plan (ESOP) is a benefit plan for employees which makes them owners of stocks in the company. ESOPs have several features which make them unique compared to other employee benefit plans. Most companies, both at home and abroad, are utilising this scheme as an essential tool to reward and retain their employees. Currently, this form of restructuring is most prevalent in IT companies where manpower is the main asset.
Description: Abroad, ESOP (where the ‘O’ often stands for ownership) is seen when employees buy over the stock of an owner or promoter who is relinquishing charge. In India, ESOP is used largely to motivate employees to put in their best and in turn, help the company enjoy lower employee turnover and retain its talent pool. These two uses probably account for over two-thirds of all ESOPs now in existence, and their numbers are expected to increase with time.
Interestingly, many companies abroad use ESOPs as a technique of corporate finance for a variety of purposes — to finance expansion, to make an acquisition, to spin off a division, to take a company private, and so on. This has yet to catch on in India, perhaps because the scale of ESOP so far is too small for many of these uses.
So far as the future of ESOPs in India is concerned, as more and more companies realise the need to retain their best talent in a world which would be dominated by companies with the best intellectual capital, this management technique would be the phenomenon of the new century.
Major Tax Benefits. ESOPs have a number of significant tax benefits, the most important of which are: Contributions of stock are tax-deductible: That means companies can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP, albeit this means existing owners will be diluted.
How an Employee Stock Ownership Plan (ESOP) Works
ESOPs Provide a Variety of Significant Tax Benefits for Companies and Their Owners. ESOP Rules Are Designed to Assure the Plans Benefit Employees Fairly and Broadly
Employee ownership can be accomplished in a variety of ways. Employees can buy stock directly, be given it as a bonus, can receive stock options, or obtain stock through a profit sharing plan. Some employees become owners through worker cooperatives where everyone has an equal vote. But by far the most common form of employee ownership in the U.S. is the ESOP, or employee stock ownership plan. Almost unknown until 1974, by 2014 6,717 plans exist covering 14.1 million employees.
Companies can use ESOPs for a variety of purposes. Contrary to the impression one can get from media accounts, ESOPs are almost never used to save troubled companies—only at most a handful of such plans are set up each year. Instead, ESOPs are most commonly used to provide a market for the shares of departing owners of successful closely held companies, to motivate and reward employees, or to take advantage of incentives to borrow money for acquiring new assets in pretax dollars. In almost every case, ESOPs are a contribution to the employee, not an employee purchase.
An ESOP is a kind of employee benefit plan, similar in some ways to a profit-sharing plan. In an ESOP, a company sets up a trust fund, into which it contributes new shares of its own stock or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.
Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting. Employees must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual.
When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value (unless there is a public market for the shares). Private companies must have an annual outside valuation to determine the price of their shares. In private companies, employees must be able to vote their allocated shares on major issues, such as closing or relocating, but the company can choose whether to pass through voting rights (such as for the board of directors) on other issues. In public companies, employees must be able to vote all issues.
Uses for ESOPs
- To buy the shares of a departing owner:Owners of privately held companies can use an ESOP to create a ready market for their shares. Under this approach, the company can make tax-deductible cash contributions to the ESOP to buy out an owner’s shares, or it can have the ESOP borrow money to buy the shares (see below).
- To borrow money at a lower after-tax cost:ESOPs are unique among benefit plans in their ability to borrow money. The ESOP borrows cash, which it uses to buy company shares or shares of existing owners. The company then makes tax-deductible contributions to the ESOP to repay the loan, meaning both principal and interest are deductible.
- To create an additional employee benefit:A company can simply issue new or treasury shares to an ESOP, deducting their value (for up to 25% of covered pay) from taxable income. Or a company can contribute cash, buying shares from existing public or private owners. In public companies, which account for about 5% of the plans and about 40% of the plan participants, ESOPs are often used in conjunction with employee savings plans. Rather than matching employee savings with cash, the company will match them with stock from an ESOP, often at a higher matching level.
Major Tax Benefits
ESOPs have a number of significant tax benefits, the most important of which are:
- Contributions of stock are tax-deductible:That means companies can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP, albeit this means existing owners will be diluted.
- Cash contributions are deductible:A company can contribute cash on a discretionary basis year-to-year and take a tax deduction for it, whether the contribution is used to buy shares from current owners or to build up a cash reserve in the ESOP for future use.
- Contributions used to repay a loan the ESOP takes out to buy company shares are tax-deductible:The ESOP can borrow money to buy existing shares, new shares, or treasury shares. Regardless of the use, the contributions are deductible, meaning ESOP financing is done in pretax dollars.
- Sellers in a C corporation can get a tax deferral:In C corporations, once the ESOP owns 30% of all the shares in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain.
- In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually the state level as well):That means, for instance, that there is no income tax on 30% of the profits of an S corporation with an ESOP holding 30% of the stock, and no income tax at all on the profits of an S corporation wholly owned by its ESOP. Note, however, that the ESOP still must get a pro-rata share of any distributions the company makes to owners.
- Dividends are tax-deductible:Reasonable dividends used to repay an ESOP loan, passed through to employees, or reinvested by employees in company stock are tax-deductible.
- Employees pay no tax on the contributions to the ESOP, only the distribution of their accounts, and then at potentially favorable rates:The employees can roll over their distributions in an IRA or other retirement plan or pay current tax on the distribution, with any gains accumulated over time taxed as capital gains. The income tax portion of the distributions, however, is subject to a 10% penalty if made before normal retirement age.
Note that all contribution limits are subject to certain limitations, although these rarely pose a problem for companies.