You may be familiar with the standard retirement plans many companies offer, like traditional 401(k)s. You might not be as familiar with a retirement benefit plan commonly called an ESOP, meaning an “employee stock ownership plan.”
ESOPs are retirement benefits that allow companies to transfer stock to a trust held for employees until they retire or leave the company. Each employee’s stock shares can grow based on the company’s profitability.
According to the National Center for Employee Ownership (NCEO), there are over 6,700 ESOPs in the U.S. These ESOPs hold assets over $1.4 trillion and cover more than 14 million employees.
What is an ESOP?
An employee stock ownership plan is a way for a company to help employees have additional income in retirement.
An ESOP retirement plan is customized based on the company. It’s usually created as part of a long-term succession plan. Using an employee stock ownership plan allows the company owner to contribute stock that employees eventually come to own, which helps fund their retirements. This can help ensure the company keeps employees motivated, even if the owner is not part of daily operations.
An ESOP works best if a company is established and has a stable financial picture.
How does it work?
To establish an ESOP, the company adds shares into a trust created specifically for the plan. Companies add shares by moving newly created shares into the trust or by contributing money to purchase existing shares. In some cases, such as a leveraged ESOP, companies can use trust funds to buy company stock and repay the loan to the trust later.
The ESOP trust then transfers shares to accounts set up for each employee, often according to a vesting schedule. Generally, employees must work for the company for a certain amount of time, often a few years, before they are 100% vested (or have 100% ownership) in the stock or employer contributions in a retirement account.
The trust holds company shares in an employee’s account until the employee retires, resigns, is fired, becomes disabled or dies. Additionally, employees never buy or hold the company stock directly. The trust must hold all company stock, and the employee receives a payout according to the vesting schedule and the value of the stock when they leave the company.
When an employee leaves or retires, the company buys back the shares in their ESOP account, either in a lump sum or through regular payments over a set time. The amount the employee receives is directly tied to the number of shares they own and the current value of those shares.
Shares bought back from former employees are often divided equally among the remaining employees and added to their employee stock ownership plan accounts. Generally, employees who leave the company can’t take the stock with them, just the cash payout based on what their shares are worth.
What are the rules of ESOPs?
Like with all retirement plans, an employee stock ownership plan has some rules that must be followed to comply with IRS requirements. Because each ESOP is specific to the company, there will be differences from plan to plan. However, there are a few basic rules that each employee stock ownership plan must follow.
Administration rules
ESOPs are administered and monitored by trustees who have to act as a fiduciary according to the Employee Retirement Income Security Act of 1974 (ERISA). Being a fiduciary means the trustee must always act in the best interest of the employee participants.
In addition, employee stock ownership plans must meet IRS nondiscrimination requirements by including a substantial percentage of regular employees (i.e., those who aren’t highly compensated) over age 21 and who have worked for the company for at least a year. A company can choose to loosen those requirements, like making eligibility available immediately, but they cannot make it harder for employees to participate in an ESOP.
Additionally, an independent appraiser must evaluate the company to determine the stock’s fair market value every year. The trustee is responsible for hiring the appraiser and ensuring their work is valid. The stock cannot be sold for more or less than the fair market value.
Withdrawal rules
An ESOP is a form of defined contribution plan, like a 401(k) is, so the IRS limits when you can access the money in your account. Like other retirement plans, you must be 59½ or older before you cash out an employee stock ownership plan (or age 55 if the company terminates you). While your plan may allow you to take early withdrawals, if ESOP participants need to access their funds before reaching age 59½, they will face a 10% penalty, plus taxes.
Distributions from an ESOP are taxable as ordinary income, just like from a tax-advantaged retirement account. If you roll over funds into a traditional IRA, you will only have to pay taxes once you withdraw the money in retirement, as long as you meet the IRA withdrawal rules.
Contribution rules
Employers can only contribute up to 25% of an employee’s eligible pay across all defined contribution plans, including ESOPs, 401(k)s, profit sharing and stock bonus plans. This means that if an employer contributes 25% of an employee’s pay in company stock to an ESOP, the company can’t contribute to other retirement plans the employee may be eligible for.
The IRS also limits the amount of compensation that is eligible for an employee stock ownership plan. In 2023, the limit is $330,000. Anything paid over that amount can’t be considered when allocating company shares.
Because an ESOP is funded with employer stock, an employee generally can’t contribute to the plan or buy shares above what the plan provides.
Advantages and disadvantages
ESOPs can significantly benefit the company owners and the employees who own the shares. Still, it’s vital to consider the advantages and drawbacks before starting an employee stock ownership plan for your company.
Advantages
- It’s free for employees. Unlike a retirement plan, like a 401(k) or IRA, the employer generally funds the ESOP. The employer covers all costs, including establishing the trust, hiring an independent evaluator annually and managing plan administration.
- It can increase employee motivation. Owning part of their company gives employees a unique incentive to see the business succeed. ESOP retirement plans can help employees take more ownership over tasks that directly contribute to profitability and improve teamwork and morale.
- Contributions are tax-deductible for the business. If the company is an S corporation, a type of business structure defined by the IRS, then contributions may be fully tax-exempt, up to the degree an ESOP owns the company. On the other hand, the money received from an ESOP is taxable as regular income. However, employees may be in a lower tax bracket in retirement and pay less in taxes overall.
Disadvantages
- The price per share can fluctuate, based on how the company is performing year to year. This is one reason ESOPs work best for consistently profitable companies with relatively predictable financials.
- Employees may want to think strategically about their retirement planning. Employees may want to time their exit in a year when the company is more profitable and thus earns a higher fair market value per share. If they leave a job during a period of low financial return, the company shares in their ESOP may be worth less than during a more profitable year.
- ESOPs require independent management and oversight. A fiduciary adviser must oversee the employee stock ownership plan and be responsible for making financial decisions in the best interest of the plan participants. Additionally, an outside appraiser must evaluate the shares every year. These advisers can be expensive, and the company bears the plan’s cost.
- It’s not recommended for startups or small businesses. ESOPs can be expensive to set up and maintain. Only financially stable companies with a history of consistent profitability should consider an ESOP. The plans can only be set up by C corporations or S corporations and have cash-flow requirements.
Are ESOPs the same as employee stock option plans?
Despite sounding similar, employee stock ownership plans are different from employee stock option plans. ESOPs are a benefit a company provides where owners slowly pass ownership to their employees over time through a trust that holds company shares.
Employee stock options are contracts between a company and its employees. Stock options give the employees the right to buy shares of the company stock at a fixed price within a certain amount of time. Only some employees are granted stock options, and the options are often used to recruit and retain top talent.
While there may be some overlap, an ESOP has strict rules and oversight about who can participate and doesn’t cost an employee anything. Employees earn the right to their shares through their employment and according to the plan’s vesting schedule.
On the other hand, stock options are only offered to some employees, who must purchase the company stock out of their own pocket or through other compensation arrangements.
Bottom line
An employee stock ownership plan can be a good way for a company to offer additional employee benefits. While there are some benefits and drawbacks, an ESOP generally encourages employee engagement and loyalty and may benefit a business through tax deductions and decreased employee turnover.
Remember that each ESOP is different. If your company offers one, thoroughly read all provided documents to understand the specific rules of your plan.
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