How an ESOP Works: The Mechanics

What is an ESOP?

Employee stock ownership plans (ESOPs) are employee benefit plans that give partial ownership of the company to individual employees. Although these plans will not work for every business, many business owners may find that the overall benefits of adopting such a plan work best for the future of the business and its employees. Companies can use ESOPs as a corporate finance strategy to align their employees’ interests more closely with those of the company. This article will discuss the mechanics behind an ESOP.

How an ESOP is Formed

To begin an ESOP formation, a company appraisal must be completed to determine the value of the company’s stock. Once the valuation is completed, a company can form an ESOP trust by either contributing a portion of its own existing stock or, more frequently, borrowing money from a qualified lender to buy shares from itself. The ESOP becomes a branch of the company, and its assets are held in a trust. The contributions made to the trust, regardless of whether the money was borrowed, are tax-deductible with limitations.

Immediately after acquiring the funds to form the trust, the company loans the funds to the ESOP trust to be secured by a pledge of shares. The loan proceeds will then be used to purchase the company’s shares. Similar to the initial appraisal, private companies are also subject to an annual external valuation as of the end of the reporting period in order to adjust the share value to the market value of the shares released, or committed to be released, from the suspense account as compensation expense.

Leveraged vs. Non-Leveraged Funding

ESOPs can either be externally leveraged when funded through outside lenders, or they can be internally leveraged when funded through the plan sponsor. When the ESOP is internally leveraged, the company presents the loan as a contra equity account on the company’s financial statements. When contributions are made each year, participants are then allocated shares. The ESOP allocation is customarily based on compensation. Most companies are required to make contributions that equal the annual loan payment but can also contribute in excess of the loan payment. Before doing so, a company should consult a tax advisor to assess the limitations on deductibility.

Alternatively, ESOPs may also be non-leveraged. This method does not involve borrowing funds from an outside lender, and contributions are made in cash or in shares directly from the employer. ESOPs are traditionally designed to have a multi-year payout of any distributions to manage the repurchase obligation.

ESOP Distribution

During the allocation, shares are transferred into individual accounts for each participant. The longer an employee stays with the company, the more shares they are entitled to through a process called vesting. If a participant leaves before they are entirely vested, they will forfeit a portion of their shares.

Buyback Obligations Upon Employee Departures

For both leveraged and non-leveraged ESOPs, there is a federally mandated repurchase obligation on behalf of the employer when an employee leaves the company. For publicly traded companies, the buyback is typically funded through the public securities market. For non-public companies, the obligation lies with the company as there is no public market for the shares.

ESOPs provide unique opportunities for business owners looking to find new ways to motivate employees, reward employees or transition out of ownership. To learn more about the mechanics of ESOPS, contact your DHG advisor or reach out to us at assurance@dhg.com.

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