Should You Participate in Employee Ownership?

You've heard the phrase "employee ownership" and you think it's something your business might want to try. But what is it, and what are the options you have?

The term "employee ownership" is the ownership of a business by its employees, usually through stock ownership via the employee's benefit plan. It usually refers to broad-based ownership (which means it's distributed among most of the employees) so the company's workforce is theoretically comprised of employee-owners. Nearly all US companies that offer any kind of employee ownership do so through an ESOP (employee stock ownership plans); other companies offer stock options to their employees or have their 401(k) plans invest in employer stock.

An ESOP offers the best tax advantage, as it's basically an employee benefit plan that operates through a trust that accepts tax-deductible contributions from the company to accumulate company stock, both new and existing. (It should not be confused with an employee stock option plan, which will be explained later.) The contributions are then divided up and sent to individual accounts. The trust can borrow money to purchase the stock, and the company repays the loan through tax-deductible contributions to the ESOP.

There are several ways to use an ESOP. Most commonly, you use the business' pretax dollars to purchase shares from an existing owner. Once the ESOP owns at least 30% of the company stock, selling any portion of the stock to the plan can make the seller eligible for a (tax-deferred) rollover on the gains when the proceeds are reinvested in other stocks. An ESOP can also borrow money to buy company shares, whether new or existing, with the company making contributions to the ESOP to repay the loan. The loan proceeds can be used for any business purpose, such as to finance new capital or refinance debt. Lastly, companies can contribute shares of stock to an ESOP for a tax deduction, or contribute money that the ESOP is able to use for purchasing treasury shares. Shares held in the ESOP are usually designated to full-time employees who have worked at least one year. Employees who leave the company retain their stock, and sometimes sell it back to the company at market value.

A stock option extends an employee the opportunity to purchase a set amount of shares at a fixed price for a given number of years. The requirements for employees who get options and how much they are allowed to get are looser than those for an ESOP. While in the past companies usually only gave stock options to a few employees, the current trend is to broaden the number to include nearly all full- or part-time employees.

You generally have two main stock options; either type may be offered to whichever employees preferred, for whatever reason, and in any quantity. The first option is called an incentive stock option (or ISO), and must meet the requirements of the IRS code for preferential tax treatment. Basically it allows the employee to defer the taxation until the shares bought with the ISO are sold and to pay tax at the appropriate capital gains tax rate instead of the usual income tax rate. The company does not get a tax deduction with an ISO.

The second option is the nonqualified stock option (NSO). NSOs do not meet the requirements for preferential tax treatment. When the employee purchases the stock, they pay regular income tax on the difference between the value of the stock and the price they paid for it. Unlike an ISO, the company does get a tax deduction; an NSO can also be given to individuals who aren't employees.

Similar to the above stock option plans is the Section 423 ESPP, or employee stock purchase plan, that's usually used in public companies. Employees with a Section 423 plan purchase stock at a discount of up to 15%. Similar to an ISO, Section 423 plans extend preferential tax treatment to employees, but they aren't allowed to be restricted to key employees. There are two other options, called a "phantom stock" and "stock appreciation rights": the former is merely a bonus to reward top employees for an increase in value of the company's stock or the dividend performance of the stock (sometimes both.) The latter is similar but doesn't offer a bonus for dividend performance.

401(k) plans are quickly becoming the employee benefit of choice. They allow employees to set money aside before taxes and save it for when they retire. Some companies will offer to match employee contributions to their 401(k) with company stock, as well as giving employees the chance to choose company stock as an investment option.

Combining employee ownership with a style of leadership that allows employees to freely share ideas and information with the company has been a proven method of successfully growing a company much faster than other methods. If you want your business to expand and thrive, employee ownership is certainly something to look into.