An employee stock ownership plan (“ESOP”) is a tax qualified employee benefit plan that provides substantial benefits to both owners and employees of closely held companies.  The employer corporation establishes the ESOP for the benefit of its employees and obtains IRS approval of the Plan document so that the plan and trust are tax qualified.  As a result, contributions to an ESOP are tax deductible to the employer and tax deferred to its participants, the same as any other qualified plan.

An ESOP operates very similarly to a profit sharing or any other type of defined contribution plan, and is subject to similar limitations on participant benefits.  Shares in the trust are allocated to individual employee accounts. Although there are some exceptions, generally all full-time employees over 21 participate in the plan. Allocations are usually made on the basis of relative participant compensation.  As participants accumulate seniority with the employer, they acquire an increasing right to the shares in their accounts through a process known as vesting. Participants must be 100% vested within three to six years, depending on whether vesting is all at once (cliff vesting) or gradual.

There are substantial additional benefits that the company and its owners as well as the employees can derive from an ESOP as follows:

• Sellers of Stock in a regular C Corporation can obtain tax deferral on the sale to the  ESOP by investing in qualified reinvestment securities.
   
• Contributions and reasonable dividends used to repay a securities acquisition loan to the ESOP are tax deductible to the employer.
   
• If the employer is or becomes an S corporation after the sale, there is no federal or (California) State income tax on the percentage of the S Corporation income allocated to the ESOP, which provides substantial tax flow advantages to everyone involved.  Indeed there are substantial tax advantages to Companies that are 100% ESOP owned.
   
• Stock contributions in kind to the ESOP are deductible to the employer.

There are many forms of transactions and methods of financing ESOP buyouts of departing corporate owners which require creative legal and financial planning and transaction structuring.  There are also issues involving ownership dilution and the obligation to ultimately repurchase shares from departing participants that must be anticipated through proper planning as well when installing an ESOP and engaging in any leveraged transactions.