Regardless of the economic climate, most people consider ways to improve their retirement savings, whether through individual investments or a retirement plan provided by their employer. In a climate challenged by talent shortages and economic uncertainties such as we’ve seen over the past few years, many employers also look for ways to attract, retain, and motivate quality people. One of the tactics that has proven successful for employees and employers both is enabling employees to share ownership in their company. Giving employees a greater sense of belonging encourages retention and elevates their desire to help the company meet its goals.
One particularly effective strategy for supporting your employees' retirement goals and strengthening your workforce is to establish an Employee Stock Ownership Plan (ESOP). Particularly for financial institutions, an ESOP presents some very real benefits. Because the benefits vary based on corporate structure, it’s important for banks to connect their employee needs, structure, and end goals before engaging an ESOP.
What is an ESOP?
An ESOP is a defined contribution employee benefit plan that allows employees to become owners of stock in their company. Both C and S corporation banks can contribute stock to an ESOP, or they can contribute cash used to acquire the company’s stock. Either method of contribution earns the bank a deduction. The bank’s contributions are deductible for tax purposes, up to the 25% of the eligible participant’s compensation. The tax benefits vary slightly for an S corporation versus a C corporation.
- S Corporation Guidelines: An S corporation does not pay federal and (sometimes) state income tax on the fraction of profits earned by the ESOP. Because income tax is not paid on the income distributions (dividends) paid to shareholders, employees typically gather more wealth.
- C Corporation Guidelines: For a C corporation, the income earned by the company shares held by the ESOP is subject to federal and state income taxes. However, if certain conditions are met, the bank will obtain a tax deduction equal to the excess of the dividends paid over the standard deduction limit (25% of covered payroll).
In some markets, a bank will raise money with loans. In these cases, only the interest is deductible. A bank also can raise capital by forming a leveraged ESOP, in which the ESOP borrows money (normally from bank or holding company) to purchase the company’s stock. The bank can make tax-deductible contributions to a leveraged ESOP to cover both interest and principal payments. A C corporation can deduct up to 25% of covered payroll for principal payments, and an unlimited amount of interest payments. An S corporation is limited to deducting 25% of covered payroll for all payments, including both principal and interest payments.
The ESOP’s valuation is extremely important. An independent valuation of the ESOP must be completed each year. If the bank contributes stock to its ESOP, a fair market appraisal must be completed on the date of contribution to determine the deduction allowed. If the bank contributes cash to purchase stock, an independent valuation must be completed on the date of the stock purchase. We recommend that banks create an annual plan to prevent the need to complete multiple valuations during the year.
An ESOP brings tax advantages and disadvantages. It’s important to consult your tax adviser to understand the structure and potential outcomes of a program. For many banks, an ESOP is a tax-effective way to increase their employees’ retirement accounts and their sense of belonging – both of which contribute significantly to higher employee satisfaction. Don’t hesitate to contact your HORNE Banking specialist with any questions, either about a current ESOP or a consideration.
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