Everything about Employee Stock Ownership Plan (ESOP)

An ESOP organization is a great way to make employees even more committed to the company, and it is also a type of reward for the founding company and the employees with favorable tax conditions. However, due to the maintenance and administration costs associated with the plan, it is worth conducting a cost-benefit analysis to ensure that the plan delivers the desired results. Many times, those who choose to retain traditional reward systems with normal tax burdens do no worse.

Who can start an ESOP organization?

Joint stock companies that want to allow their employees to acquire a stake in their company can start an ESOP. In the case of limited liability companies, this option is available if their parent company, which operates as a public limited company, starts an ESOP organization, and extends its influence over it to its subsidiary.

This organizational form allows the employer not to hand over securities directly to the employees, but to the ESOP organization it established, in which the employees acquire a member’s interest. This ensures that employees are committed to the business and can also be rewarded in for of dividends without having the right to make decisions about the operation of the business.

Conditions for establishing an ESOP organization

One of the main conditions for establishing an ESOP is a remuneration policy. It sets out the process for accounting for employee income, ensures equality between participating employees, and presents the company’s indicators for the future. The latter is important because when establishing an ESOP organization, the expectation of the founding company is to continuously improve these indicators and the profit. Nevertheless, for further smooth operation, it is important to create a contract system that prevents dilution trends in the main decision-making body.

ESOP Taxation

The popularity of ESOPs lies in favorable taxation. ESOP members can acquire shares tax-free and the reward earned in an ESOP organization is classified as capital income. Thus, members earn income on more favorable terms than the reward they receive as wages. Capital income is taxed at a much lower rate that the taxes and contributions of employees and employers levied on traditional cash rewards.

Financial statements and accounting requirements

As ESOP organizations are other organizations according to the Accounting Act, they are subject to Government Decree 479/2016 (XII.28.). The form of the financial statements to be drawn up depends on the following end values. If the sales revenue from the core business and business activities does not exceed HUF 50 million in the two financial years preceding the financial year concerned, the organization may draw up abbreviated financial statements, otherwise it must prepare abbreviated annual financial statements. An ESOP organization is obliged to draw up annual financial statements if for two consecutive financial years any two of the following three indicators exceeds the given values: balance sheet total? HUF 1,200 million, sales revenue: HUF 2,400 million, average number of employees:50.
In the case of other registered organizations, the financial statements must be disclosed in accordance with the provisions of the Accounting Act. If an organization is not registered with a court of registration, it must disclose key information about its financial statements in the manner specified in its accounting policy. The accounting system depends on the form of the financial statements. An entity preparing abbreviated financial statements is required to keep single-entry bookkeeping but may switch to double-entry bookkeeping on 1 January of any year if it continues to prepare abbreviated annual or annual financial statements. It is also important that the organization’s accounts include the revenues and expenses of its core business covered by specific legislation separately from the business activities defined by separate legislation.

 Disadvantages of an ESOP

Given that the establishment of ESOP organizations has not been widespread among Hungarian companies for a long time, a stable regulatory and legislative framework has not yet been established, which can sometimes lead to uncertainties.
The members’ shares must be recorded according to strict rules. The company is required to record changes and value the shares at market value, which involves an audit.
There are costs associated with maintaining an ESOP, the most common of which are the rental or maintenance fee for the registered office, the fee for the trustee responsible for the shares, the executive’s salary, and the costs of accounting and auditing.

Accounting for major economic events related to ESOP organizations

The cash and non-monetary contributions made available as founders’ assets specified in the instrument of constitution shall be shown as the initial capital of ESOP organizations. Assets made available by the founder to the ESOP organization are accounted for as staff costs by the founder, while the ESOP organization will have a share in the founding company, which is to be recognized as financial investments,
The share returned to the founder may be made for consideration or free of charge. If the founder acquires the share for consideration, it is included in financial investments or current assets at the purchase price. Members’ shares transferred to the founder free of charge are accounted for as financial investments or current assets, depending on maturity, and the related profit shall be accrued. The accrual is reversed when the cost is recognized as an expense.
If securities sold to members of an ESOP organization are recorded as financial investments, the resulting exchange difference shall be recognized as income from or expense on participating interests, if they are recorded as current assets, it should be recognized as other income from financial transactions or other expenses on financial transactions.
It is the responsibility of the founding company to cover the maintenance costs of an ESOP organization. In term of the nature of this payment, it is a non-repayable support provided to compensate costs, so it is recognized as other operating charges by the founder and other income by the ESOP organization.