The Difference Between Employee Stock Owner Plans & Employee Stock.
Investing in your company's ESOP may allow you to live your retirement years more comfortably.
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An employee stock ownership plan (ESOP) and employee stock purchase plan sound similar, but have vastly different effects on a company and its employees. An ESOP can become a critical part of a company's operations, but stock plans mostly just help a business recruit talent. Although an ESOP can have huge tax advantages, it also requires much more administrative labor than a stock plan.
Identification.
An ESOP qualifies as a retirement plan, such as a 401 (k) or individual retirement account, while corporations use stock options as an employee benefit, like health insurance. In an ESOP, the company contributes to employee retirement plans with its own stock. This might occur through cash or securities contributions to the plan, or by allowing the ESOP to obtain a bank loan to purchase shares from the company. Under a regular stock option plan, the business grants qualified workers the right to purchase company stock at a discount once the employee meets certain criteria, such as staying with the company for three years. For example, a corporation might allow employees to purchase 500 shares in the company at $10 at any time in the next five years. Alternatively, the company could allow the worker to wait to exercise his options until shares in the company reach a certain price.
Tax Advantages.
A company can deduct contributions or loan repayments to an ESOP. Once the ESOP owns 30 percent of the company, the owner can defer taxable gains on the sale of his shares if he reinvests the money in a qualified security, such as another company. An S-Corporation does not pay taxes on the portion of the company held by the ESOP. For example, if an ESOP holds 60 percent of an S-Corporation, the corporation only pays taxes on 40 percent of its profits. Employees do not pay taxes on ESOP contributions and can defer paying taxes on gains until retirement. When a worker does pay taxes, he usually pays the much lower capital gains rate. Workers receiving stock under an incentive stock option plan usually only pay taxes on the capital gain. However, if the employee does not hold the stock for a certain period of time, usually a year, he pays taxes on the sale like ordinary income. Employees pay for stock options using after-tax earnings.
Companies use ESOPs and stock options to attract employees and keep them working to improve the company. However, ESOPs have some business functions. For instance, owners sometimes use an ESOP as an exit strategy because they might escape taxes on the sale of the company. An ESOP can improve cash flow because of the deductions for contributing to the plan. Also, the company can match employee savings with stock instead of cash, which means it has more cash on hand to expand.
Considerations.
Consult an attorney and financial adviser to decide on how to compensate employees with stock. Setting up an ESOP usually requires at least $40,000 to the most basic plan, according to the National Center for Employee Ownership. Any S-Corporation may start an ESOP, but partnerships and most professional corporations cannot legally use one. Sometimes an ESOP has a negative effect on employee morale. For instance, employees might resent owning part of the company but not having any say in management. Moreover, employees put the bulk of their retirement savings in the company. If the company undergoes bankruptcy, participants in the ESOP can lose their entire retirement savings.
References (6)
About the Author.
Russell Huebsch has written freelance articles covering a range of topics from basketball to politics in print and online publications. He graduated from Baylor University in 2009 with a Bachelor of Arts degree in political science.
Photo Credits.
Siri Stafford/Photodisc/Getty Images.
More Articles.
ESOP Payout Rules.
What Are the Benefits of Employee Stock Options for the Company?
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Fast Answers.
An employee stock ownership plan (ESOP) is a retirement plan in which the company contributes its stock (or money to buy its stock) to the plan for the benefit of the company’s employees. The plan maintains an account for each employee participating in the plan. Shares of stock vest over time before an employee is entitled to them. With an ESOP, you never buy or hold the stock directly while still employed with the company. If an employee is terminated, retires, becomes disabled or dies, the plan will distribute the shares of stock in the employee’s account.
This type of plan should not be confused with employee stock options plans, which are not retirement plans. Instead, employee stock options plans give the employee the right to buy their company’s stock at a set price within a certain period of time.
The U. S. Department of Labor’s Employee Benefits Security Administration, not the Securities and Exchange Commission, oversees ESOPs. If you have a question about your ESOPs, please contact: :
U. S. Department of Labor.
Employee Benefits Security Administration.
Division of Technical Assistance and Inquiries.
200 Constitution Avenue, NW, Room N5625.
Washington, D. C. 20210.
Toll-Free: 1-866-444-EBSA (3272)
Phone: (202) 219-8776.
If you have a complaint about your plan, you can learn the procedures for filing a claim on the EBSA’s website. For help in finding a lawyer who specializes in pension matters, you can visit the website of the National Pension Lawyers Network. You can find information about pensions from the EBSA’s home page.
For more information about ESOPs, take a look at the website of The National Center for Employee Ownership.
Stock Options, Restricted Stock, Phantom Stock, Stock Appreciation Rights (SARs), and Employee Stock Purchase Plans (ESPPs)
Stock Options.
A company grants an employee options to buy a stated number of shares at a defined grant price. The options vest over a period of time or once certain individual, group, or corporate goals are met. Some companies set time-based vesting schedules, but allow options to vest sooner if performance goals are met. Once vested, the employee can exercise the option at the grant price at any time over the option term up to the expiration date. For instance, an employee might be granted the right to buy 1,000 shares at $10 per share. The options vest 25% per year over four years and have a term of 10 years. If the stock goes up, the employee will pay $10 per share to buy the stock. The difference between the $10 grant price and the exercise price is the spread. If the stock goes to $25 after seven years, and the employee exercises all options, the spread will be $15 per share.
Kinds of Options.
If all the rules for ISOs are met, then the eventual sale of the shares is called a "qualifying disposition," and the employee pays long-term capital gains tax on the total increase in value between the grant price and the sale price. The company does not take a tax deduction when there is a qualifying disposition.
Exercising an Option.
Accounting.
Restricted Stock.
Phantom Stock and Stock Appreciation Rights.
Employee Stock Purchase Plans (ESPPs)
Plans not meeting these requirements are nonqualified and do not carry any special tax advantages.
Stay Informed.
Our twice-monthly Employee Ownership Update keeps you on top of the news in this field, from legal developments to breaking research.
Related Publications.
You might be interested in our publications on this topic area; see, for example:
CEPI Exam Quick Reference Guide.
A quick reference guide to equity compensation in the form of four double-sided laminated sheets.
GPS: Stock Options.
A guide to administrative and compliance issues for stock option plans in US public companies.
Securities Sources for Equity Compensation, 2017 ed.
A book with source documents for those working with equity compensation.
Selected Issues in Equity Compensation.
A detailed look at some of the main topics in equity compensation. Includes a comprehensive chapter on ESPPs.
GPS: Performance Awards.
Discusses administration, financial reporting, and communication issues for public companies that grant performance awards.
Equity Compensation for Limited Liability Companies (LLCs)
A guide to creating equity compensation arrangements for limited liability companies (LLCs). Includes model plan documents.
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