As a business owner, employee stock plans can provide you with an additional incentive structure for your employees to participate in the upside potential of your company, as well as a vehicle through which you can eventually transition ownership. 

There are two main types of employee stock plans: Employee Stock Ownership Plans (ESOPs) and Employee Stock Purchase Plans (ESPPs). If you are considering one of these incentive plans for your company, you should consider the following important differences as part of your planning process.

ESOPs: Compensate Employees with Company Ownership

One primary way to differentiate an ESOP from an ESPP is that the former requires no contribution from your employees. Instead, an ESOP compensates them in the form of your company’s stock, which is held in a trust. 

Because an ESOP is a qualified plan according to the IRS, your employees do not need to pay income tax on stock they receive as compensation from the plan until they make a distribution of their shares. 

Your business can also receive significant tax benefits from an ESOP. For example, your company will receive tax deductions for contributions of either new shares of its stock, or of cash to buyback existing shares from employees. You can fund the cash portion of your ESOP using loans, which makes financing stock purchases in an ESOP potentially more attractive than ever in today’s historically low interest-rate environment.

Another significant tax benefit of ESOPs: If you structure your company as an S Corporation, the business can also defer paying federal (and sometimes state) taxes on future business profits (until the eventual disposition of stock). This tax shield becomes most impactful when the ESOP’s ownership stake in your company equals 100%.

What are the downsides to an ESOP? One of the big ones is that it is usually much more expensive to set up and administer. Annual costs include appraising the value of the stock as well as purchasing stock from departing employees.

Also, the potential tax benefits of an ESOP may be too far in the future if your company is not likely to be profitable in the near-or medium-term.

Another concern may be if you would like to sell your stake in the company to an external third-party. In this case, you could be leaving some upside on the table. ESOPs are designed to provide you with a reasonable fair market value for your company at the time of your desired exit but may not account well for unexpectedly superior bids on your business in a hot M&A market. 

Finally, you cannot create an ESOP for a sole proprietorship or partnership-structured business. Only S- and C-Corporations can set up an ESOP which are best suited for privately held companies. While publicly traded companies can set up an ESOP, the expense and contributions to these plans generally reduce earnings and may increase corporate leverage, typically making them a less favorable option when answering to public shareholders versus other employee incentive alternatives.

ESPPs: Employees Purchase Stock at a Discount

Unlike an ESOP, an ESPP does not provide additional compensation to your employees, but instead gives your employees an opportunity to buy the company’s stock through payroll deductions. Unlike ESOPs, employees can optionally make purchases of stock in an ESPP with their own after-tax dollars.

ESPP plans are usually better suited for publicly traded companies. Private companies will not choose ESPPs because they would then need to create a market for their stock to avoid triggering regulations of  the Securities and Exchange Commission, which could be costly and time consuming. 

There are two types of ESPP plans: one is the more common “qualified” ESPP, also known as a 423 plan. The second is a “non-qualified” ESPP.

Unlike a non-qualified ESPP, a qualified 423 plan can offer employees a discount of up to 15% on share purchases. Employees who are less than 5% owners in the stock may contribute up to $25,000 in a calendar year to a 423 plan. Your employees will not have to pay taxes on any share discount at the time of purchase. 

In addition, your employees may receive more favorable long-term capital gains treatment on shares acquired within a qualified ESPP, if they are held for at least two years after the grant date and one year after the purchase date (whereas with a non-qualified plan, your employees would have to pay ordinary income tax on any gains realized over the purchase price, at the time of purchase). 

So why would you consider a non-qualified ESPP? In a word, it can be more flexible than a 423 plan, for certain objectives. 

For example, you may decide it is better for your company to offer employees a share match as opposed to a share discount. Unlike a 423 plan that allows a maximum 15% share discount, the non-qualified ESPP plan does not impose limits on share matching. You could also add a vesting schedule to a non-qualified ESPP to better align your incentives. Finally, there are no employee contribution limits imposed on a non-qualified ESPP.

Which Employee Stock Plan is Best for You?

There is no one-size-fits all strategy when it comes to properly incentivizing your employees. At Modera Wealth Management LLC, our team of professionals can help you untangle the complexities of different employee stock plans – including their tax implications and flexibility – in order to devise the best incentive and retention strategy for your company.

Information sourced from Modera Wealth Management in Atlanta, GA

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