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ESOPs belong to a broad category of employee benefit
plans known as defined contribution plans. Like a small
private bank, a defined contribution plan maintains a separate
personal account for each participating employee. There are
two types of ESOPs -- leveraged and nonleveraged.
Additionally, ESOPs may be combined with or converted from other
employee benefit plans.
Nonleveraged ESOPs
A nonleveraged ESOP is a stock bonus plan, identified as an ESOP in
the plan document, that invests primarily in company stock and meets
certain legal requirements. The sponsoring employer
contributes newly issued or treasury stock and/or cash to buy stock
form existing owners. Contributions generally may equal up to
15% of covered payroll (which usually is the combined payroll of all
employees eligible for participation) or, if the ESOP includes a
money purchase pension plan in which the employer commits to
contribute a set percentage of covered payroll per year in cash or
stock, 15% plus the money purchase pension plan contribution
percentage (from 1% to 10%) up to a maximum of 25% of covered
payroll.
Leveraged ESOPs
A leveraged ESOP borrows money on the credit of the employer or
other elated parties to buy company stock. It is the only
qualified employee benefit plan that can do this. A loan from
an outside lender can be to the ESOP itself, or to the employer,
which then relends the money to the ESOP (lenders generally prefer
lending to the employer). The loan from the company to the
ESOP does not have to be on the same terms, provided its terms are
sufficiently fair to the ESOP to be the equivalent of an "arm's
length" transaction. The loan can be used for any business
purpose, such as buying stock from an existing shareholder,
acquiring new capital, buying a company, or refinancing debt.
ESOPs Combined With
Other Plans
An ESOP, leveraged or not, can be combined with another benefit
plan. This provides some security through diversification if
the company goes bankrupt, because then the company stock held by
the ESOP may become virtually worthless. One popular
combination is using leveraged ESOP contributions to fund the
company match in a 401(k) plan. Of course, ESOPs can also
exist side by side with 401(k) or other benefit plans without being
combined with them.
Converting Other Plans
to ESOPs
Any qualified plan may be converted to or replaced with an ESOP. An
existing defined contribution plan, such as a profit-sharing
plan, can be converted into an ESOP without terminating it.
Any conversion of a plan that involves using the old plan's
assets to acquire company stock, however, involves fiduciary issues
that must be carefully considered.
For more information on this,
review our services or
request our free brochure "An Introduction
to ESOPs."
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