Employee Stock Ownership Plan (ESOP)

The ESOP is a stock bonus plan with an important additional feature: If certain requirements are met, the plan can be used by the employer company as a means of raising funds on a tax-favored basis. The funds can be used for any corporate purposes, which can include acquiring the assets or stock of another company.

In effect, an ESOP allows an employer to indirectly borrow money from a bank and repay the loan with fully deductible repayment amounts. The repayment amounts are deductible in full because they are structured as contributions to an ESOP; normally, only the interest portion of a loan repayment would be tax deductible.

This bit of tax magic (see Figure1) is accomplished by first having the plan trustee borrow money from a bank or other lender. The borrowed money is then used to purchase a block of employer stock from the employer. Shares of this stock also will subsequently be allocated to participants' accounts in the ESOP as plan contributions are made. The employer makes periodic plan contributions to the ESOP and obtains a tax deduction for them. These plan contributions are designed to be enough to enable the plan trustee to gradually repay the loan to the bank. The net result is that the employer immediately receives the full proceeds of the bank loan and in effect pays off the loan through tax-deductible contributions to the plan on behalf of plan participants.

Figure1

Because the ESOP normally has no financial status independent of the employer, the employer usually must guarantee the loan to the bank. If the plan gives collateral for the loan, the collateral may consist only of qualifying employer securities.

Contribution Formulas and Accounts

An ESOP's contribution allocation formula may not be integrated with Social Security because plan allocations must be based on total compensation. In other respects, contribution formulas and participants' accounts are handled in the same manner as for the stock bonus plan described earlier.

Deductibility of Contributions

The rules for contribution deductibility for an ESOP are somewhat different from those for a stock bonus plan or profit-sharing plan. If employer contributions to the ESOP are applied to the repayment of a loan, amounts applied by the plan to repay the loan principal are deductible by the employer up to a limit of 25 percent of compensation of employees covered under the plan. Amounts used to repay interest are deductible without any percentage limit.

Plan Distributions

The distribution rules, voting rights, and taxation considerations regarding ESOP distributions are the same as those discussed earlier in connection with stock bonus plans.

Diversification Requirement

To reduce investment risks, participants in ESOPs who have reached age 55 with ten years of service are entitled to an annual election requiring the employer to diversify investment in the participant's account. The plan must offer at least three investment options, other than employer stock, to the participant for diversification purposes.

Creating a Market for Closely Held Stock

In small companies, it is often important for shareholders to find a market for their stock for financial and estate planning purposes. Many types of plans have been designed to enable the use of company funds for purchasing stock, such as stock redemption and corporate-owned life insurance plans. An ESOP or stock bonus plan can also be helpful for this purpose. The shareholder can sell stock to the plan during lifetime or at death, generally with favorable tax results. These techniques involve various complexities and must be designed with some care.