Marc Ang helps you decide whether a stock bonus plan or an Employee Stock Ownership Plan (ESOP) makes more sense for you, by laying out the basics.
Sometimes you don’t want to compensate your employees with cash.
Equity compensation has become more and more prevalent, especially in a world of tech startups that end up going public (i.e. Facebook) or getting bought out in a big way (i.e. Instagram, Snapchat).
It also makes most sense in a performance-based environment.
We will discuss two types of plans:
- Stock Bonus Plan
- ESOP (Employee Stock Ownership Plan)
Stock Bonus Plan
A stock bonus plan is similar to a defined contribution profit sharing plan.
- However, instead of cash contributions from the employer, it is in the form of stocks.
While contributions are discretionary, there are certain rules for these employer contributions, such as substantiality and recurring contributions, and nondiscrimination.
Another requirement is that employees who receive this stock must have voting rights.
Another requirement is a put option, where the employee can terminate employment and has the right to sell back the stock to the employer in exchange for cash.
- The value of the stock the employer contributed is tax-deductible.
- Employees’ interests are aligned with the company’s success.
- Like cash plans, a 2-6 year gradual vest or a 2 year cliff vest is available.
- Great for companies that need to be tight on cash (i.e. startups).
- Social security integration is available, reducing the plan’s exposure in paying benefits to an employee. (not available with an ESOP)
- Employee has a non-diversified portfolio.
- The put option, which could cause cash flow issues.
- When the employer contributes, the stock needs to be valuated (there’s a cost for this).
Employee Stock Ownership Plan (ESOP)
The Employee Stock Ownership Plan (ESOP) takes things to the next level. By establishing a trust, administration requirements increase. However, it further ties employees’ performance to the company’s success to a level that a regular stock bonus plan doesn’t.
How this is more of an “intense” version of stock bonus plans:
- In a leveraged ESOP (the company takes a loan), the interest on the loan is also tax-deductible. Contributions and dividends are always deductible.
- For closely held private companies (this does NOT apply to public companies), they can take advantage of a non-recognition of gain treatment, subject to certain rules.
- Valuation is required not just for private company stocks contributed to the plan, but also the dividends.
- Stricter portfolio diversification requirements. When a participant is 55, and has been a participant in the plan for 10 years, the employee can choose to diversify out of the company stock (25% the first 5 years, and up to 50% on the sixth year)
- For closely held companies, participants have a say in voting on major corporate decisions (mergers, acquisitions, consolidation, reclassification, liquidation, dissolution, recapitalization, etc).
- More tax write-offs, such as the interest on the loan in a leveraged ESOP and the non-recognition of gain treatment with private companies. (the single most important benefit of an ESOP)
- Interests are even more aligned between employees and the company.
- Vesting schedules are available, enforcing long term gratification.
- Social Security integration is not allowed with an ESOP, while it is with a stock bonus plan.
- Stricter portfolio diversification requirements.
- The put option once again, could cause cash flow issues.
In a nutshell, it probably makes more sense to do an ESOP once your private company has grown to a point where it is stable enough in the long-term. Meanwhile, a stock bonus plan can be good for a smaller company that has irregularities in cash flow. These are generalizations. Every company deserves a deep dive discussion about what plan makes sense. Maybe these two options aren’t even appropriate for your business’ goals and needs. Contact us today for a free initial consultation.
Marc Ang (Mangus) is a financial planner based in Claremont, CA, focused on spreading the gospel about responsible, educated and smart financial planning.