Harless Tax Blog

Harless Tax Blog

ESOPs as Retirement Plans

Friday, May 19, 2017

Among the retirement plans that small businesses can offer to their workers are employee stock ownership plans (ESOPs). As the title indicates, an ESOP is a process for transferring ownership of the company to employees. How does that work as a retirement plan?

In some ways, an ESOP is similar to a profit-sharing plan (see the CPA Client Bulletin, January 2017), in which the company makes cash contributions. With a “vanilla” or unleveraged ESOP, the company funds the plan by contributing shares of its stock, or cash to buy those shares.

Uniquely among retirement plans, ESOPs can be leveraged. In one scenario, the ESOP borrows money from a financial institution or from another party, then uses the borrowed funds to purchase shares of the employer’s stock. Once the shares are in the plan, they are allocated to accounts of participating employees, generally all full-time workers over age 21. Assuming the company’s shares are not publicly traded, annual independent appraisals track the value of the company’s shares, which in turn determine the value of each participant’s ESOP holdings.

Current law calls for gradual vesting of all employer contributions over six years, or complete vesting at three years. When employees leave the company, at retirement or sooner, they receive their vested shares. The employer is required to buy back the shares, at the currently appraised price. Therefore, a long-time ESOP participant could retire with a substantial amount from the plan.

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