An employee stock ownership plan is a sort of employee benefit plan, designed to reward them with an ownership interest in the company. In other words, an employee stock ownership plan is a profit-sharing plan, a strategy used by the companies to align the interest of the employees and the shareholders. In this case, a company sets up a trust fund, into which it contributes new shares of its stock or cash to buy existing shares. ESOPs give the company, the employees and other participants several tax benefits.
An ESOP is usually formed to aid succession planning in a closely held company by allowing employees the opportunity to buy stocks. Employee stock ownership plans are set up as trust funds, funded by companies with newly issued shares into them, using cash to buy existing company shares, or borrowing money through the entity to purchase company shares. ESOPs are used by companies of all sizes, including blue-chip ones.
Why companies use ESOPs?
As ESOPs are part of the company remuneration package, companies can use ESOPs to keep all the participants focused on the company performance and the share price appreciation. By including employees at all level engaged, even at the company’s stock level, the participants do what’s best for company shareholders, as they are now shareholders. To sum it up, an employee stock ownership plan gives an employee a sense of ownership in the company, which in turn boosts his confidence and pushes him to work harder for the organization.
Employee stock ownership plans are used to buy shares of a departing owner. Secondly, employee stock option plans can be used to borrow money at a lower after-tax cost. The ESOPs can borrow cash, which it could use to buy company shares or shares of existing owners. Employee stock option plans are also used to create additional employee benefit. A company can issue new or treasury shares to an ESOP, deducting its value from taxable income.
Cost and tax implications for ESOPs
Companies usually provide employee stock ownership plans to the employees with no upfront costs. The company may keep the stocks in a trust for safety and growth until such time the employee resigns or retires. The companies tie distributions from planning to vesting – the proportion of shares earned for each year of service.
Employee stock ownership plans are often taxed. When an employee exercises his option, the difference between the exercise price and Fair Market Value (FMV) as on date of exercise is taxed as a perquisite. Employee stock ownership plan is considered as perquisites concerning taxation.
While selling, if the employee sells these shares at a price higher than the FMV on the exercise date, he would encounter capital gains tax. The capital gain is again taxed as per the period of holding. This period is calculated from the date of exercise up to the date of sale.
However, employee stock ownership plans supposedly have several tax benefits. For example, companies can get a tax benefit by issuing new shares or treasury shares to the ESOP. Secondly, a company can contribute cash on a year-to-year basis and take a tax deduction for it. The contribution is often used to buy shares from current owners or to build up a cash reserve in the employee stock option plans for future use.
Advantages and disadvantages of ESOPs
Stock options are provided as a reward to employees. It’s an incentive for the employees to work harder. Hence, motivation, employee retention and an award for hard work are the key benefits which ESOP brings to the employers. Employee stock ownership plans are a way to reward the employees without cash compensation, as it saves on immediate cash outflow. For a lot of organizations that are now expanding their business, awarding their employees with ESOPs work out to be a more workable option than the cash rewards.
However, a lot of ESOP companies run the risk of issues and potential violations of their ESOP work, when they employ a third-party firm to manage it. When ESOPs are involved, the company needs to be aware of the ongoing costs. In case, the cash flow dedicated to ESOPs limits the cash available for reinvesting in the business over a long-term, the ESOP scheme isn’t a good fit for such a company.
Experts say that companies that require additional capital must avoid employee stock ownership plans. The ESOP schemes are used to fund the purchase of the shares from its shareholders. In the case of a financial crisis, when the company would need additional capital for its working capital, the expenses for ESOPs would create a burden.
There are also other forms of employee ownership such as stock options, restricted stocks, phantom stocks and stock appreciation rights. However, ESOPs are considered to be beneficial for companies with a long-term objective. It is a definite way to make the employees stakeholders of the company. Companies that are unable to offer handsome packages could use ESOPs to make their compensation package look attractive and competitive.