Definitions

Employee ownership

Employee ownership

Employee ownership occurs when a corporation is owned in whole or in part by its employees. Employees are usually given a share of the corporation after a certain length of employment or they can buy shares at any time. A corporation owned entirely by its employees (such as a worker cooperative) will not, therefore, have its shares sold on public stock markets. Employee-owned corporations often adopt profit sharing where the profits of the corporation are shared with the employees. They also often have boards of directors elected directly by the employees. Some corporations make formal arrangements for employee participation, called Employee Stock Ownership Plans (ESOPs).

Employee ownership appears to increase production and profitability, and improve employees' dedication and sense of ownership. However, critics caution that democratic leadership can lead to slow decision-making, and employee stock ownership can increase employees' financial risk if the company does poorly. Notable employee-owned corporations include the John Lewis Partnership in the UK, and the US firm Tribune Company.

Most features of employee-owned corporations described in this article are not specific to any one nation. The information on taxation and stock trading refers to United States law and may differ elsewhere.

Benefits to employees

There are several rationales for employee-owned corporations in the U.S. First, there are substantial tax benefits for employee ownership companies. Employee stock ownership plans (ESOPs) are set up by companies as a kind of employee benefit trust. An ESOP is a type of employee benefit plan designed to invest primarily in employer stock. To establish an ESOP, a firm sets up a trust and makes tax-deductible contributions to it. All full-time employees with a year or more of service are normally included. The ESOP can be funded through tax-deductible corporate contributions to the ESOP. Discretionary annual cash contributions are deductible for up to 25% of the pay of plan participants and are used to buy shares from selling owners. Alternatively, the ESOP can borrow money to buy shares, with the company making tax-deductible contributions to the plan to enable it to repay the loan. Contributions to repay principal are deductible for up to 25% of the payroll of plan participants; interest is always deductible. Dividends can be paid to the ESOP to increase this amount over 25%. Sellers to an ESOP in a closely held company can defer taxation on the proceeds by reinvesting in other securities. In S corporations, to the extent the ESOP owns shares, that percentage of the company's profits are not taxed: 100% ESOPs pay no federal income tax. Employees do not pay taxes on the contributions until they receive a distribution from the plan when they leave the company; even then they can roll the amount over into an IRA.

Stock acquired by the ESOP is allocated to accounts for individual employees based on relative pay or some more equal formula. Accounts vest over time, usually following one of two formulas: in the first, vesting starts at two years and completes at six; in the second, participants become 100% vested after four years. When employees leave the company, they receive their vested ESOP shares, which the company or the ESOP buys back at an appraised fair market value. ESOP participants must be allowed to vote their allocated shares at least on major issues, such as closing or selling the company, but are not required to be able to vote on other issues, such as choosing the board.

Employees also can acquire stock through grants of stock options, the right to buy shares at a price set today for a defined number of years into the future. There are no special tax benefit associated with most forms of stock options, however. Employees can also become owners by purchasing shares in a stock purchase program, usually at a discount, by buying stock in their 401(k) savings plans, or by companies making matches of company stock to employee deferrals into these plans. Stock in 401(k) plans can be bought with pretax income, while company contributions are tax-deductible.

Altogether, there are about 11,500 ESOPs covering 11 million employees, almost all in closely held companies. The other forms of ownership generally occur in public companies, and another estimated 15 million employees participate in one or more of these plans (see data from the National Center for Employee Ownership).

Disadvantages to Employees

Diversification has been cited as an issue, and there are examples to support this belief. Employees at companies such as Enron and WorldCom lost much of their retirement savings by over-investing in company stock in their 401(k) plans, though these specific companies were not employee-owned. But, studies in Massachusetts, Ohio, and Washington state show that, on average, employees participating in the main form of employee ownership, employee stock ownership plans (ESOPs), have considerably more in retirement assets than comparable employees in non-ESOP firms. The most comprehensive of the studies, a report on all ESOP firms in Washington state, found that the retirement assets were about three times as great, and the diversified portion of employee retirement plans was about the same as the total retirement assets of comparable employees in equivalent non-ESOP firms. Wages in ESOP firms were also 5% to 12% higher. National data from Joseph Blasi and Douglas Kruse at Rutgers shows that ESOP companies are more successful than comparable firms and, perhaps as a result, were more likely to offer additional diversified retirement plans alongside their ESOPs. The data is also available at www.nceo.org

Employee ownership in 401(k) plans, however, is more problematic. About 17% of total 401(k) assets are invested in company stock--more in those companies that offer it as an option (although many do not). This may be an excessive concentration in a plan specifically meant to be for retirement security. In contrast, it may not be a serious problem for an ESOP or other options, which are meant as wealth building tools, preferably to exist alongside other plans. Detailed data on 401(k) plan investments are available at www.ebri.org, the home page of the Employee Benefits Research Institute.

Accounting for ESOPs

The accounting for ESOPS have evolved over a period of time. The most widely accepted GAAP on ESOP is the SFAS 123 (R) issued by the FASB, US. Earlier SFAS 123 allowed a public entity to adopt either the "intrinsic value" method or the "fair value" method of accounting. However, in Nov 03, the FASB brought out a revised SFAS 123 which specifically states that public entities shall only use "fair value" method.

The fair value method states that the compensation cost in respect to the ESOPs shall be measured at a fair value based on either an Options Pricing Model like the Black-Scholes-Merton Model or any Binomial model like the Lattice; and such fair value be recognized at the measurement date. Such compensation cost recognized shall be allocated to compensation expense over the vesting period based on the service period of the employee. At the end of each accounting period, the fair value recognized earlier shall be reviewed for any change of plan; and appropriate entries for the same be passed thereby reducing/increasing the compensation expense.

Taxation of ESOP in India

Under Income Tax Act, the shares alloted to employee under Government approved ESOP is not taken as perquisite. However , now fringe Benefit Tax is applicable on the ESOP shares .The law however , recently amended that companies can recover the amount of FBT paid for ESOP. Employees will have to pay for capital gains tax if sold within a year of allotment of shares. However , sale after holding shares for more than a year and sale taking place through recognize stock exchange , the gain is tax free u/s 10(38) of the I T Act. Read frequently asked question on taxation of Employees Stock Option Scheme (ESOP)in India

References

See also

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