Companies with ESOPs and other broad-based employee ownership plans account for well over half of Fortune magazine's "100 Best Companies to Work for in America" list year after year.

1. What is it?
 

A stock bonus plan is a qualified employer plan — similar to a profit-sharing plan — in which participants' accounts are invested in stock of the employer company. An ESOP is a stock bonus plan that the employer can use as a conduit for borrowing money from a bank or other financial institution.

2. Why should you consider establishing an ESOP?
 

a. To provide a tax-advantaged means for employees to acquire company stock at low cost to the employer.

b. When estate and financial planning for shareholders would benefit from the additional market for company stock created by a stock bonus plan or ESOP. Moreover, an ESOP not only creates a market but provides the opportunity for estate tax benefits for a sale of stock to the ESOP.

c. To provide an advantageous vehicle for the company to borrow money for business needs.

d. When a company wants to broaden its ownership — for example, to help prevent a hostile takeover of the company.

e. When the business is a corporation. Partnerships do not have stock and thus are ineligible to establish an ESOP or stock bonus plan. S corporations are permitted to establish an ESOP or stock bonus plan; however, they are not eligible for all the tax benefits provided to C corporation ESOPs.

f. When the employee group as a whole is not clustered in the older ages.

3. What are the advantages?
 

a. Employees receive an ownership interest in the employer company, which may provide a performance incentive.

b. A market is created for employer stock, which helps improve liquidity of existing shareholders' assets or estates and helps in business continuity planning.

c. Employees are not taxed until shares are distributed. Furthermore, unrealized appreciation of stock held in the plan might not be taxed to employees at receipt of distributions from the plan. Taxation of the unrealized appreciation can generally be deferred until shares are sold by the employee.

d. The employer receives a deduction either for a cash contribution to the plan or a noncash plan contribution in the form of shares of stock.

e. The overall cost of corporate borrowing can be reduced by using an ESOP.

f. A shareholder can obtain tax benefits by selling stock to the plan.

4. What are the disadvantages?

a. Since the plan is qualified, all the qualified plan requirements apply — coverage, vesting, funding, reporting and disclosure, and others.

b. Issuing shares of stock to employees "dilutes" (reduces the relative value of) existing shareholders' stock and their control of the company.

c. Company stock may be a very speculative investment. This can create employee ill-will, either because the plan is not considered very valuable by employees or because employees expect too much from the plan.

5. What about design features?

ESOPs and stock bonus plans are qualified defined contribution plans similar to profit-sharing plans. However, participants' accounts are stated in terms of shares of employer stock. Benefits are generally distributable in the form of employer stock. Dividends on shares can be used to increase participants' accounts or can be paid directly in cash to participants. If dividends are paid directly in cash, the employer gets a tax deduction and the dividends are currently taxable to the employees.

Employer contributions are either shares of stock, or cash that the plan uses to buy stock.

Plan allocation formulas must not discriminate in favor of highly compensated employees and are typically based on employee compensation. For example, if total payroll of participating employees is $500,000 and the employer contributes stock worth $50,000, an employee earning $10,000 would be allocated $1,000 worth of stock under a compensation-based allocation formula. As with all qualified plans, only the first $245,000 of compensation (in 2011, as indexed) can be used in the plan's allocation formula. The formula for a stock bonus plan can be integrated with Social Security, but this is rarely done. An ESOP formula cannot be integrated.

If shares of the employer company are closely held — that is, not publicly traded on an established securities market — and more than 10 percent of the plan's assets are invested in securities of the employer, then plan participants must be given the right to vote on certain specific corporate issues: (a) approval or disapproval of any corporate merger or consolidation, recapitalization, reclassification, liquidation, or dissolution; (b) sale of substantially all assets of the trade or business; or (c) a similar transaction as prescribed in IRS regulations.

If employer stock is publicly traded, plan participants must be allowed to vote the stock on all issues.

Distributions from stock bonus plans and ESOPs are subject to the same rules applicable to all qualified plans. For example, distributions prior to age 59½, death, or disability are subject to a 10 percent penalty, with some exceptions. Note, however, that a stock bonus plan or ESOP is generally not required to provide a joint and survivor annuity or other spousal death benefit.

Note: The content in this publication is not intended or written to be used, and it cannot be used, for the purposes of avoiding U.S. tax penalties. It is offered with the understanding that the writer is not engaged in rendering legal, accounting, or other professional service. If legal advice or other expert assistance is required, the services of a competent professional should be sought.