Return to Retirement Plans        

The Basics: The ESOP is essentially a stock bonus plan in which employer stock may be used for contributions.

1. Employer contributes company stock or cash to the plan.
2. Employer contributions are tax deductible. IRC Sec. 404(a)
3. Contributions are not taxed currently to the employee. IRC Secs. 402(a) and 403(a)
4. Earnings accumulate income tax-deferred. IRC Sec. 501(a)
5. Distributions can be tax-favored (eligible for 5 year forward averaging or rolled over into an IRA) at retirement. IRC Sees. 402 and 403
6. An ESOP plan additionally includes 401(k) features.

Additional Considerations

A. Maximum Annual Deduction Up to 15% of covered payroll (up to 25% for a leveraged ESOP) can be contributed and deducted by the corporation.

B. Individual Limits: The annual allocation of contributions to a participant’s account is not to exceed the lesser of 25% of includable compensation or $30,000 per year.

C. Employer Contributions

D. Excluding Persons: Certain persons can be eliminated on the basis of months of service, age and coverage in a union plan; for example, persons under age 21 can be excluded from the plan.

E. Investment of Plan Assets: Plan assets are required to be invested in employer stock with some exceptions for those participants nearing retirement. In addition, assets may be used to purchase life insurance in some circumstances.

F. Forfeitures: As participants leave the company and separate from the plan, those less than 100% vested forfeit that part of the account in which they are not vested. The nonvested forfeitures may then be allocated to the remaining participants. Those participants who remain in the plan the longest will share in the most forfeitures.

G. Plans which are Favored: Typically; younger participants are favored because they have a longer tine for their fund to grow. Also, there may be some special advantages to the major shareholders.

The risk of poor investment returns rests upon the employee. However- if the investment results are favorable; the participant will have a larger fund at retirement age.

Top-Heavy Plans

More than 60% of the plan assets are allocated to key employees the employer must contribute at least as much for non-key participants as it does for key employees. This requirement applies only to a contribution of up to the first includable compensation (higher in some instances).

1. Under an ESOP the participants have the absolute right to demand distribution of company stock.
2. The plan may repurchase the distributed shares of stock but is not required to do so only the employer is
   so required.
3. The plan must pass certain voting rights through to the participants.
4. If the stock is not publicly traded or is restricted, the participant or his or her heirs must have the right to offer the stock for sale to the employer.
5. The plan may borrow money from a bank to purchase stock with the employer guaranteeing such loan, without it being considered a prohibited transaction.
6. The plan may borrow money from a prohibited person without incurring any penalty. IRC Sec. 4975(d)(3)
7. The plan may not be integrated with Social Security.
8. Whereas a stock bonus plan is not required to invest in employer securities an ESOP must invest primarily in employer securities.
9. The employer can contribute company stock directly to the plan.
10. The plan may purchase the securities on the open market for public companies, from the company itself or from the shareholders.
11. The employer can contribute and deduct up to 25% of compensation for a leveraged ESOP which is repaying loan principal. In addition, it can make deductible contributions to pay interest on the loan used to purchase securities.

1. Contributions are tax deductible.
2. Contributions and costs are totally flexible.
3. The plan is easy to understand by the employees.
4. It can provide employees with permanent life insurance benefits that need not expire or require costly conversion at retirement age.
5. Since all or substantially all of the assets maybe invested in employer's stock, this is a good method for raising additional capital without going to the market place.
6. In effect, the corporation can raise capital with deductible contributions to its plan.
7. Stock, rather than cash, can be contributed to the plan.
8. An ESOP may be used to facilitate the buyout or a stockholder.
9. Dividends paid on stock and owned by the ESOP may be deducted if they are passed through
   in cash to the participants. (They are not eligible for the dividend exclusion.)
10. In effect both the interest and principal of loans are made on a deductible basis.

1. Annual employer contributions are not taxed to the participant.
2. Earnings on the account are not currently taxed.
3. Distributions at retirement may be tax4avored.
4. Special treatment of unrealized gains upon the distribution of stock permits significant tax deferral.
5. Participants can also have a traditional, deductible IRA, or a Roth IRA. Subject to certain income level limitations based on filing status.
6. There is the ability to purchase significant permanent life insurance, which is not contingent upon the company group insurance program. Purchase of life insurance will generate taxable income to the employee (PS Sg).
7. Younger employees can accumulate a larger fund than with a defined benefit plan.
8. The forfeited, unvested portion of accounts of former participants is allocated to the active participants' accounts. This can have a substantial impact on the future benefits.
   
9. Employee participates in employer's growth.
10. A potential market is created for deceased owner's stock.
11. The ESOP can provide significant estate planning benefits for shareholders.
12. The gain on the sale of employer securities to the ESOP can be deferred under certain situations.
13. Employee can borrow from the plan within certain legal guidelines, if provided for in the plan documents.

1. The ESOP will generally not produce as large of a contribution and deduction for older employees as will a defined benefit plan.
2. Contribution limitations are set at 15% of covered compensation, except for some special circumstances with leveraged ESOPs.
3. Certain voting rights roust be passed through to the participants.
4. Having the stock valued and appraised each year may be costly.
5. Future repurchases may not come at a convenient time and must be made with after-tax dollars. This could place a financial strain on the employer.

1. There is no guarantee as to future benefits.
2. Investment risks rest on the participant.
3. There is no assurance as to the frequency and amount of employer contributions.
4. Older participants may not receive as great of a benefit as with a defined benefit plan.
5. The value of closely held stock may be difficult to determine at retirement age.
6. If the founder or key people die, retire, or terminate employment, the stock may be worth very
   little.
7. The Company may not be financially able to repurchase the stock, even though required to do
   so.
8. If the employer's stock is depressed in value at retirement time, there could be a significant loss in the
   retirement account.