ESOP or Employee Stock Ownership Plan
ESOP is the most common kind of employee ownership plan used in the US.
Are you considering offering ESOPs (Employee stock ownership plan) to your employees, or are you an employee and about to receive ESOP as a bonus from your company? You may have many questions about what an ESOP is and how it works. Regardless of if you are an entrepreneur, employer or employee, you should know all about the benefits of ESOPs along with all the ESOP rules and regulations.
To begin with, an ESOP is the most common kind of employee ownership plan used in the US. In fact, there are about 6,669 ESOP plans all around the US, covering about 14.4 million people nationwide. So, as ESOPs are becoming increasingly more popular among companies, it is high time for you to take advantage of this. Here, you will learn all you need to know about ESOPs.
What is an ESOP or Employee Stock Ownership Plan?
An ESOP, or employee stock ownership plan, offers workers ownership interest through employee stock options in the company. This plan is created to offer the employees the chance to purchase stock in a closely held company to promote company growth.
Since ESOP shares are a part of a bonus package for an employee, companies use ESOPs to keep the plan participants focused on share price appreciation and corporate performance. ESOPs encourage employees to do what is best for both the company, and in turn, the shareholder with the appreciation of their stock. The owners also enjoy tax benefits by offering ESOPs to their employees. And with these share plans, employers can retain the best talent by offering extra incentives for their staff, which would help grow the company.
But just to be on the safe side, these companies usually add a vesting schedule within the ESOP. This helps protect the company in case the employees leave the company before the ESOPs fully vest. When the shares become fully vested and if the employees choose to stay with the company, they can keep the shares and become a shareholder. If they choose to resign or retire from the company, and the shares are fully vested, the company can repurchase the shares. Otherwise, these shares are automatically forfeited and taken back from the shareholder.
Note: Employees that retire or resign usually cannot take the shares from the ESOP with them. They are only allowed to take a cash payment obtained from it. On the other hand, the employees that have been let go usually qualify for the amount that they have vested in the plan.
Why do companies offer ESOPs to their Employees?
The answer to this question is very simple; employers use ESOPs to attract and retain the highest quality employees by offering them employee stock options in the company. And these shares are distributed by the employer in a phased manner. For example, the employer can grant their employees with stock options at the close of the financial year. This would incentivize the employees for staying with the company longer to get the option grants.
In fact, most IT companies have alarming attrition rates (staff turnover rates). And by offering employee stock option plans to the employees, it would help the company bring down the heavy turnover. Moreover, many startups like these are cash-strapped and aren’t able to offer a high starting salary. Due to this, they offer a stake in their organization, making their package highly competitive in the market and attracting talented people.
How do Employees Benefit from an ESOP?
We now know why ESOPs are great for employers, but what benefit does it offer to employees? Before we cover the benefits, let us understand how an employee needs to look at these employee stock options. When an employee is offered a job that includes ESOPs, they should analyze how the long-term value of the employee stock ownership plan compares to the earning opportunities in other companies.
Basically, the employee has to access the number of stocks they can get in their time with the company and how it would benefit them in the long-term. And if it is seen that the ESOP offering would benefit the employee in the long-term, that is when it makes sense to stick with the company. Otherwise, the employee should consider other options if the stock options are not worth it.
Here are some of the basic benefits of an ESOP for employees:
- ESOPs offer job security, non-monetary benefits, and satisfaction to the employees.
- Responsibility of the employees towards the company elevates, which also motivates them to participate in the decision making of the company actively.
- Assurance of a comfortable retirement for employees.
- Financial benefits in the form of share benefits, higher pay, and wealth generation.
There are a lot of success stories of employees who have become rich after they were offered employee stock options in their company. One such example is Google. Here, both the founders and the stockholder employees became millionaires. The chief executive of Google, Charlie Ayers, obtained employee stock options from the company worth $26 million.
Pros and Cons of ESOP
With that said, and the benefits of these for an employee understood, let us talk about the many pros and cons of ESOPs. These would cover both from the standpoint of the employer and employee. The following would help you understand this better:
Advantages of ESOP
As mentioned above, the benefits of ESOPs for the employees are numerous. To begin with, employees get shares in the company which can be sold later on. Additionally, the employees can help with the running of the company when a buyout has been completed.
But that is not all! Another big benefit of ESOPs for business owners is the tax treatment it gets. To help you understand better, here are some of the main benefits of an ESOP:
- Built-in buyout: Employees that have access to an ESOP do not have to wonder when or if they will get the chance to purchase the business, because everything has already been set up for them.
- No cost to employees: The employees do not have to pay anything for the ESOP unlike a 401(k), where a part of their contributions are used to cover the plan administration costs.
- No taxes for employees: There aren’t any taxes on ESOP plan contributions. It is only applied to the distribution that may be deferred in case you roll it into an IRA.
- Great for drawing top employees: In case you are an employer who is offering ESOP in your company, you will be able to get the best talent in the industry who would help you grow your business and increase the value of your company. And when the value increases, so does your dividends (being the owner of the company) as well as the profits.
- Tax-deductible contributions: The contributions of ESOPs are tax-deductible for business owners. In short, it helps the owners in reducing their tax liability.
Disadvantages of ESOP
As for the disadvantages, there is virtually no ESOP drawbacks for employees, except that their ESOP may take the place of profit-sharing or cash bonuses. Additionally, employees might not have a way where they can protect their investment in the company in case the plan does not give them the ability to make management decisions for the company.
To help you understand better, here are the disadvantages of ESOPs:
- Expensive for employers: ESOPs are very expensive for businesses to administer and implement.
- Have to ensure the business is run for the plan’s benefit: The owners of the business that have an employee ownership stock plan in place owe a fiduciary duty to the shareholders of the company. This means that they need to run the company for the benefit of the plan and cannot take excessive compensation from the company.
- Employees may not have control: Although employees will be invested in the company and to grow it through employee stock options and its plan, their plan may not give them the right to make decisions for the company. In short, this would make it difficult for employees to protect their investment in the company.
In the end, just remember that the positive points outweigh the negative ones. And there is a lot of great benefits of ESOP that you can easily benefit from.
Types of ESOP
Although this article focuses on unleveraged ESOP to make you understand its basic idea, there are many other ESOP types. There are three main kinds of ESOPs that employers can use to transfer partial or full ownership of a company to their employees. Each of them has been briefly explained below:
This is the least common form of ESOP. The company that uses the issuance ESOP makes regular contributions to the plan, comprised of newly issued shares of the company stock rather than cash. This is a great plan for those owners who want to issue new shares to the plan instead of contributing profits to the plan. But with this plan, the owners of the business eventually have their ownership shares diluted over time as the number of outstanding shares increase.
This is a very common kind of ESOP plan and are a great choice for those owners who want to be bought out quickly. In this ESOP, a plan takes out one or more loans from lenders or banks. These borrowed funds are then used to purchase shares in the company from the current owners. The company then makes frequent contributions to the ESOP which are used to pay the loans. With the leveraged employee stock ownership plan, the business owners can structure a loan for the ESOP to purchase a huge number of shares in the company at once instead of purchasing shares in little pieces over time.
This is the most basic kind of ESOP. Using the unleveraged ESOP, a company makes periodic contributions to the plan. This is then used to purchase the shares in the company from the current owners. The unleveraged employee stock ownership plan is the best plan for owners who want to be bought out over time. It is also an ideal way to reward employees that stay with the company for a long period of time.
How does ESOP Vesting work?
Companies who offer ESOPs to their employees tend to add a vesting schedule on it. Vesting schedules are outlined in the employee stock ownership plan document. And if the employee leaves the company before the shares are completely vested, they would have to forfeit some of the stock. The maximum time for a vesting schedule is six years as per the IRS.
As per the IRC Section 411, employers who use an ESOP vesting plan can select from two kinds of vesting schedules. One is the graded vesting where the shares are vested in even amounts for several years, but all shares have to be vested within 6 years. The other one is the cliff vesting schedule, where all the shares are vested at once within no more than 3 years. In short, these are ESOP rules and regulations that have to be followed strictly.
ESOP Vesting Minimum Requirements
Although employees whose plans are subjected to an ESOP vesting schedule can vest faster than these minimum requirements, the IRS doesn’t allow this as per their ESOP rules and regulations. Also, note that the vesting does not take place for each year individually but all at once. For instance, if an employee is covered by cliff vesting leaves the company during the fourth year, this person can keep 100% of their shares in the ESOP and not just the shares purchased within the first two years. In short, there are minimum vesting requirements that every business has to meet to use the ESOP.
ESOP Immediate Vesting
Nonetheless, business owners can include faster vesting schedules in their plan documents. Some ESOPs immediately vest stock owned by employees through an ESOP. Those shares can be sold at any time or kept if an employee leaves the plan.
ESOP Tax Benefits
As mentioned earlier, ESOP taxation for employees is very low and also offers tax benefits to the employers. Employees do not have to pay any tax on the employer’s contributions to the plan. And there aren’t any tax implications as the employees accumulate ownership via the ESOP. The only tax that employees pay in the employee stock ownership plan is on the profit distributions and the individual retirement account (IRA).
To help you understand better, here are some employee ESOP tax considerations:
- Taxes on profit distributions: Employee distributions from the ESOP are taxable. But you can have it taxed as capital gains instead of income or rolled into an IRA with all the taxes deferred.
- No taxes on accumulated ownership percentage: There are no taxes on the increased ownership in the business of the employees through an ESOP.
- No taxes on contributions to repay ESOP loans: If your ESOP borrows money to purchase shares in the company, contributions used to repay the loan are not taxable for employees. Additionally, they are also tax-deductible for employers
- No taxes on employer contributions: Employers’ contributions of stock or cash are tax-deductible to the employer up to 25% of the total payroll of the company. The contributions are also not taxable to the employees.
Note: Along with the capital gains or income taxes on ESOP distributions, employees might also be subject to a 10% penalty if they take distributions before the age of 59 ½.
ESOP Tax Benefits for Small Business Owners
An employee stock ownership plan also offers many tax benefits to small business owners. Employers can contribute either stock or cash, which is tax-deductible for the company using ESOPs. One of the biggest advantages of an ESOP is that if the company is completely owned by an ESOP, then it is exempt from corporate income tax.
Along with the tax-deductible ESOP contributions, business owners can easily get additional tax benefits from selling their stock to an ESOP. For instance, business owners can easily defer capital gains from their sale of stock to an ESOP as soon as the plan owns more than 30% of the company. To do this, company owners must reinvest any money they earn when the ESOP buys their shares.
Being an employer that offers ESOPs, you will need to follow some of the ESOP rules and regulations to ensure that your plan is not disqualified. You will need to add vesting schedules in the structure of the ESOP, which meets the required minimum standards set by the IRS. Additionally, you also need to ensure that all the eligible employees are enrolled in the plan. Here are some of the important ESOP rules to follow:
- Meet ESOP vesting requirements: The ESOP can either have the cliff or graded vesting in it. But the shares have to be vested after no longer than a 6-year graded or a 3-year cliff vesting period.
- Employee representation: The employee stock ownership plan needs to have a trustee appointed to represent the interests of the employee participants.
- Pay ESOP taxes: The employee getting the ESOP distributions need to pay the taxes on the profits gained. But the employer can get about 25% of their tax deducted from the company’s payroll for the employer’s contributions.
- Follow vesting guidelines: If you include an ESOP vesting schedule in your plan document, ensure that it follows the 401(k) vesting schedule.
Enroll all eligible employees: Employees who are eligible for an ESOP cannot be excluded unless they opt-out of it.
- ESOP contribution limits: Employer contributions to an ESOP cannot exceed 30% of EBITDA. (Earnings before interest, tax, depreciation and amortization)
Failure to follow these rules can cause the employer or the plan to incur penalties. So, if you work in a company that offers ESOP, ensure that the company is following the rules.
Common Questions Asked about ESOP
For those who have some doubts, here are some common questions that will help you understand ESOPs better:
#1 What is an ESOP?
An ESOP (employee stock ownership plan) is an employee benefit plan that offers workers in a company with an ownership interest in the company. The owners in the company set up the ESOP plan to attract and retain the best talent in the industry. Read this article from the beginning to understand ESOPs better.
#2 How does an ESOP work?
In an ESOP that has been established by the owners of the company, the plan either receives contributions or borrows funds from the company, which is then utilized to buy the shares in the business. With this, the owners of the company can easily transfer partial or full ownership of the company to the employees and enjoy multiple ESOP taxation benefits.
And using the structure, the ESOP would be operated and run its life course. The owners also appoint a trustee or committee who oversees the plan and ensures that it follows the plan document.
#3 What happens to ESOP if your company Sold?
There are a lot of cases that can take place when your company is sold. In the first case, let us say that your company is sold to another ESOP company. Here, you would have your ESOP shares rolled over into the shares of the new company employee stock ownership plan. In other cases, the acquiring company would cash out all your shares and roll the proceeds into an account in your name in their 401(k) plan. There are cases where the company might buy your shares and give you the cash.
Regardless of whatever happens, you need to know that most acquisitions take time. Even if a company has been purchased, the funds in the ESOP can be held in an escrow account until all the remaining issues in the sale are complete, such as satisfying certain conditions for the sale or resolving any liabilities the company may have.
#4 How to cash out an ESOP after quitting?
With an employee stock ownership plan, you would get stock of your company for free as per the ESOP plan. And if you decide to leave the company, have become disabled, or retire from your job, you can expect to get the distributions from the beginning of the next year based on the ESOP plan document. If you pass away at any point, your beneficiaries would get the distributions in the next year. And if you are laid off or quit your job, you might not get the distributions for up to six years.
Here are some additional points you should keep in mind:
- Your Annual Account Statement: According to the law, your company has to send you an annual statement that reports the amount of stock and cash in your ESOP account. This will also have all the details of the vesting schedule and how many shares have vested. You can get a copy of this from your HR department.
- Deferred ESOP Distributions: As mentioned above, if you are laid off or quit, the ESOP distributions are deferred for six years under IRS regulations. After six years, you will get the value of your ESOP in either partial payments over five years or in one lump-sum. The lump-sum distribution can consist of stock, shares or a combination of both, and the annual portion would be in stocks.
- Your ESOP Distribution Policy: Ensure that the ESOP has a distribution policy that outlines exactly how the shares, stock or cash will be distributed.
- Retirement Account Transfers: If you want to stay safe from paying a 10% penalty on your early ESOP withdrawal, it is better to roll over the money in your ESOP into a retirement account (such as an IRA). And once you become 59 ½ years old, you can withdraw it and avoid penalties. But remember that you will still have to pay the income tax for the profits gained.
In short, an ESOP is a great plan not just for the employees but also for the company. And being an employer, as you give out shares from your company, remember to keep track of it. You can use Eqvista, which is a cap table software that would help you to easily track and manage the shares in your company.