Employee ownership: The basics

Employee ownership refers to ownership of a business by its employees, generally (in the U.S.) through stock ownership of a corporation through an employee benefit plan.

More specifically, we use it to mean ownership that is broad based -- that is, distributed among most or all of the employees, so that the company has a workforce of employee-owners. There are about 15,000 companies in the U.S. that share ownership broadly with employees. Over 10,000 of these are employee stock ownership plans (ESOPs), about 2,000 are companies that give stock options to most employees, and another 2,000 are companies whose 401(k) plans invest heavily in employer stock.

Employee Stock Ownership Plans (ESOPs)
The ESOP is the most tax-advantaged mechanism for companies to share ownership with employees. An ESOP is an employee benefit plan operating through a trust that accepts tax-deductible contributions from the company to accumulate company stock, which is then allocated to accounts for individual participants. The ESOP can acquire both new and existing stock. The trust can borrow money to purchase the stock, with the company repaying the loan by making tax-deductible contributions to the ESOP.

ESOPs can be used for a variety of purposes, such as:

• To buy the shares of an owner in a closely held company: The most common application for an ESOP is to use the company's pretax dollars to fund an ESOP (or to pay an ESOP loan) to buy shares from an existing owner. Once the ESOP owns 30% or more of the company's stock, any sales of stock to the plan can qualify the seller for a tax-deferred rollover of the gains when the sale proceeds are reinvested in other stocks and bonds.
• To borrow money: An ESOP can borrow money to buy new or existing company shares, with the company repaying the loan in pretax dollars by making contributions to the ESOP. The loan proceeds can be used to buy a division from a parent, finance new capital, refinance existing debt, buy out an owner, or for any other business purpose.
• To create an employee benefit plan: Companies can simply contribute new shares of stock to an ESOP and take a tax deduction for them, or contribute cash that the ESOP can use to buy treasury shares.

Shares held in the ESOP trust are generally allocated at least to all full-time employees with a year or more of service, either on the basis of relative pay or some more level formula. When employees leave the company, they get their stock and can (if the company is closely held) sell it back to the company at an appraised fair market value.

Employee Stock Options and Related Plans
A stock option gives an employee the right to purchase a set amount of shares at a fixed price for some years into the future. Please note that ESOP does not stand for "employee stock option plan"! ESOPs and stock options are entirely different. Generally speaking, the rules for who gets options and how much they get are much looser than for ESOPs. In the past, companies usually gave stock options only to "key" employees. Nowadays, more and more companies give options to most or all employees.

There are two main types of stock options. Unlike ESOPs, either type may be granted to as few or as many employees as the company desires, on any basis, and in any quantity:

• Incentive stock options: ISOs must satisfy the conditions of the Internal Revenue Code for preferential tax treatment. An ISO generally allows the employee to defer taxation until the date the shares bought with the option are sold and to pay tax at the applicable capital gains tax rate rather than the(higher) ordinary income tax rates. The company does not get a tax deduction.
• Nonqualified stock options: NSOs are options that do not satisfy the Internal Revenue Code's conditions for preferential tax treatment. When the employee "exercises" the option by buying the stock, he or she pays ordinary income tax on the "spread" between the value of the stock and the price paid for it.However, the company receives a tax deduction on the spread. Unlike ISOs, NSOs can be given to nonemployees.

Related to stock options are "Section 423" employee stock purchase plans (ESPPs), which are usually used in public companies. In a Section 423 plan, employees buy stock at up to a 15% discount. Like ISOs, Section 423 plans offer preferential tax treatment to employees if certain rules are satisfied; unlike ISOs, Section 423 plans cannot be limited to top employees.

You may also have heard about phantom stock. This is a bonus that rewards employees based on the increase in value of the company's stock, the dividend performance of the stock, or both. Stock appreciation rights (SARs) are similar, and in effect consist of phantom stock without phantom dividends. Neither type of plan is suited for broad-based use but rather for key employees.

401(k) Plans
401(k) plans are a fast-growing form of employee benefit. They allow employees to put money aside on a pretax basis and save it for retirement. Many companies now match the employee contribution with company stock, as well as allow employees to choose company stock as one of their investment options.

Employee Ownership and Corporate Performance
Research shows that when employee ownership is combined with a management style that encourages employees to share ideas and information, companies grow 6% to 11% per year faster than would be expected otherwise.

— Copyright 2007, Inc.com