Employee Stock Option Plan
An employee stock option plan (ESOP) is a tax-qualified retirement program that owns stock of the sponsoring company for the benefit of its employees. It is important to note that an ESOP is subject to the same regulations and limitations as any tax-qualified retirement program, such as a 401(k).
What makes an ESOP different from other plans is that it is effectively used as a corporate finance tool as well as retirement vehicle for its participants. The major distinction between an ESOP and other plans is that an ESOP can borrow money to purchase its sponsor's stock either from shareholders or directly from the company.
Shareholder advantages of an ESOP:
- Efficient way to transfer ownership in the company to the employees
- Advantages to shareholder who elects to hold stock until deceased, estate can use the ESOP to provide a mechanism for the agency to redeem stock on a tax-deductible basis
- Tax advantages and liquidity opportunities
Company advantages of an ESOP:
- Company can raise capital at a reduced cost
- Leveraged ESOP allows for deduction of both principal and interest costs
- Agency owners can gain liquidity for all or a portion of their ownership within the agency
- Ease of accessing capital
- Substantial tax incentives
Life insurance is commonly used to fund ESOPs repurchase obligation funding. ESOP-owned life insurance is certainly attractive in the short run since the premiums on the insurance will be made with pre-tax dollars (if ERISA limits are complied with). This will also avoid any alternative minimum tax liability if the ESOP is the beneficiary.
The advantages of having Corporate owned life insurance (COLI) are significant:
- Tax-free cash (subject to alternative minimum tax) received as death proceeds and can be loaned to the ESOP, company makes tax-deductible contributions to repay itself
- Corporation may wish to retire stock, using life insurance
- Premiums on COLI can become tax-deductible, by having the corporation annually contribute an amount of newly issued shares equal in value to the premiums paid
- Investment returns of highly rated life insurance companies may be competitive with other conservative investment options
In summary, maintaining the insurance with the corporation as owner, beneficiary and premium payer retains a great degree of flexibility for the corporation, maximizes the tax benefits of COLI, and reduces fiduciary risk.
COLI are fairly complex in nature. Call us at 866-452-3670 or email sales@pipaclife.com to help you develop the right solution for your clients interested in exploring the many advantages ESOPs afford their business succession plans.
