Employee Stock Ownership Plans (ESOP) - Essay Example

It is governed by ERISA (Employee Retirement Income Security Act). A stock option gives an employees of an organisation the right to buy shares at a price fixed (usually the market price, but sometimes lower) for a defined number of years into the future. Several options such as those based on the percentage of pay basis, a merit formula, an equal basis, or any other formula the company chooses might be granted (NCEO, 2005). According to the US Securities and Exchange Commission "an employee stock ownership plan (ESOP) is a retirement plan in which the company contributes its stock to the plan for the benefit of the company's employees" (SEC).

ESOPs were given a specific statutory framework in 1974. (NCEO, 2005) and through the plan employees are allowed to own stock in their companies without having to purchase shares (Employee Stock). ESOPs are generally more common among closely held companies and are usually created when a retiring owner wants to transfer ownership of the company to one or more employees (Employee Stock). Similar to other qualified deferred compensation plans, a company's ESOPs must not discriminate in their operations in favour of highly compensated employees, officers, or owners (NCEO, 2005).

To achieve this, companies are required by law to appoint a trustee to act as the ESOP's plan fiduciary. This fiduciary could be anyone, while larger companies tend to appoint external trust institutions; smaller companies typically appoint a manager or create an ESOP trust committee. (NCEO, 2005)In setting up an ESOP, a company first approaches a lender to borrow money; this is known as a "leveraged" ESOP. In this approach, the company first sets up a trust, which then borrows money from a lending institution.

The company then repays the loan by making tax-deductible contributions to the trust, which the trust gives to the lender. The loan however must and can only be used by the trust to acquire stock in the company. Benefits of ESOP's.The objective of most stock option plans is providing a kind of investment for employees so they also can become part owners of a company. It has been observed that companies with employee-owners often boast higher productivity and increased employee loyalty, longevity and satisfaction.

This is due to the fact that the employees are indeed co-owners of the companies and this is translated into benefits such as: efficiency and productivity. According to management experts the best way to make employees owners is to give them shares in the company rather than asking them to pay for their shares. Another advantage of the ESOP is that it costs the employees nothing to co-own the company and after employees leave the company or retire, the company distributes to them the stock purchased on their behalf, or its cash value (NCEO, 2005).

In return for agreeing to funnel the loan through the ESOP, the company can save money through a number tax is deferments until the employee retires (Employee Stock). This is done in a number of ways: First, the company can deduct the entire loan contribution it makes to the ESOP, within certain payroll-based limits as allowed by law. This means that a company can in effect deduct both interest and principal on the loan, not just interest. Secondly, the company can also deduct dividends paid on the shares acquired with the proceeds of the loan that are used to repay the loan itself (in other words, the earnings of the stock