Unless bankers have participated in a qualified retirement plan that invests in employer stock early in one’s career, many know little about employee stock ownership plans (ESOPs). Here’s some information about ESOPs to add to your knowledge base.
ESOPs invest in the bank’s stock
An ESOP is a qualified retirement plan that invests in the bank’s own stock. The bank can contribute stock to the plan or it can contribute cash used to acquire bank stock, which is allocated to employees’ accounts. In a leveraged ESOP, the plan acquires a large block of shares from the bank or its shareholders by borrowing money from another bank, usually at favorable rates.
As with other qualified plans, your bank’s contributions to the ESOP are tax deductible (generally up to 25% of eligible participants’ compensation). In addition, ESOPs must comply with specific rules and regulations, including strict nondiscrimination requirements. Closely held banks must have their stock valued by a qualified, independent appraiser when it establishes the ESOP and annually thereafter.
When ESOP participants retire, die, become disabled or terminate their employment, their benefits are distributed as stock or cash. Closely held banks are required to give employees a “put option” — that is, the right to sell the stock back to the bank at its current fair market value. Some banks limit stock ownership in the corporation so that participants must sell their stock to the bank or the plan at distribution. These options can generate significant “repurchase liabilities” that your bank should plan for and monitor.
Equity attracts employees
Equity is a powerful incentive you can use to attract, retain and motivate employees. Sharing ownership with employees through an ESOP also ties them to your community bank and aligns their interests with your objectives and strategies. As your bank grows and its stock value increases, employees share in the success.
Another advantage of an ESOP is that your bank can spread the wealth in a tax-advantaged manner. Earnings and appreciation on stock held by an ESOP are tax-exempt, so employees’ accounts grow on a tax-deferred basis. Participants recognize taxable income only when they withdraw their benefits from the plan. Distributions are taxed the same as 401(k) plans and other qualified plans, including a penalty for withdrawals before age 59½, with certain exceptions. Additionally, like a 401(k), distributions from the ESOP must begin in the year the employee reaches age 70½.
The bank and owners also benefit
An ESOP provides several benefits for your community bank and its owners. For example, the bank’s ESOP contributions are tax deductible (up to applicable contribution limits) and, under certain circumstances, it can deduct dividends paid on ESOP shares.
Also, a leveraged ESOP can be a highly tax-efficient vehicle for raising capital. Ordinarily, only interest is deductible on a business loan. But your bank can make tax-deductible contributions to a leveraged ESOP to cover both interest and principal payments.
For closely held banks, an important benefit of an ESOP is that it creates a market for the existing owners’ stock without necessitating a sale to “outsiders.” By selling a portion of the business to an ESOP, the owners can generate income or diversify their portfolios while retaining control of the bank.
And if the ESOP owns at least 30% of a C corporation bank’s stock immediately after the sale, the owners can defer their capital gains indefinitely by reinvesting the proceeds in qualified replacement property (QRP) within one year. QRP includes most stocks and bonds issued by publicly traded domestic operating companies.
Pros and cons for S and C corporations
ESOPs offer some remarkable opportunities for banks organized as S corporations. Notably, as pass-through entities, S corporations pay no entity-level taxes. Instead, shareholders report their share of the corporation’s profits, losses and other tax attributes on their personal income tax returns. Being tax-exempt, an ESOP wouldn’t pay tax on the S corporation’s profits.
One significant disadvantage for S corporations (over their C corporation counterparts) is that owners can’t defer the gain on the sale of their stock to an S corporation ESOP. Additionally, the contribution limit to an S corporation ESOP is 25% of compensation for both principal and interest. There are a plethora of other considerations for both S and C corporations, which will require the advice of your bank’s financial and tax advisors.