Types of ESOPs

An employee stock ownership plan, or ESOP, is a retirement plan that invests in just one asset: the employer's stock. The company places stock in the ESOP for workers, and at retirement, they get to draw it out. If the company's done well, the employee can sell the stock and turn a profit. Different ESOPs use different methods to fund the account.

Basic ESOP

The basic or non-leveraged ESOP works very simply. Every year, the employer puts money in the account, and then the plan takes the money and buys up shares of company stock. Alternatively, the company can just contribute the stock directly. All the contributions are tax-deductible. The company can write off contributions up to 15 percent of the total cost of payroll. Another advantage is that unlike leveraged ESOPs, the basic plan doesn't require the company to take on debt.

Leveraged ESOP

Leveraged ESOPs use debt to fill the plan accounts. The company borrows money from the bank and uses that to buy its own stock. This burdens the business with more debt than a basic plan does, but the company can write off the loan up to 25 percent of payroll costs. Normally, paying off a loan isn't tax-deductible except for the interest. If the company needs money to expand, borrowing through an ESOP gives it money plus a tax break.

Leveraged Buyout ESOP

A leveraged buyout ESOP is a tool used when one of the owners wants to sell off his investment. Like a regular leverage deal, the ESOP takes out a loan, but instead of the company issuing new shares, the plan buys the owner's stock. If the owner structures the deal carefully, his taxes on a leveraged ESOP buyout will come out much lower than if an outside investor had paid the same price for the stock.

Things in Common

All three types of ESOP have a few things in common. A corporation can't set up any kind of ESOP until it's shown a profit for at least three years. Because the government watches ESOPs very carefully to ensure employees get a fair shake, they're expensive. It can take $35,000 to $50,000 to start the plan and $5,000 to $10,000 a year to follow through on all the reporting and appraisal requirements.