Employee Stock Ownership Plan Vesting

Being a business owner, you might offer a number of benefits to incentivize your employees, including nice year end bonuses and health insurance. While these may work great in the short term, you should consider a more concrete plan to keep your best workers in the company for the long term.

One of the best options that you can offer your employees is an ESOP, which is an employee stock option plan. This will share the ownership of the company to your employees, allowing them to contribute and benefit from the success of the company.

ESOPs are growing in popularity for small businesses. As per the National Center for Employee Ownership (NCEO), in 2018, there were about 6,500 ESOP programs covering around 14 million participants in the US alone. And the reason why many companies are opting to use this is simple. ESOPs are the best way to both help the company grow and compensate your employees.

So, what is ESOP?

An ESOP is a qualified employee benefit plan that offers employees with an ownership interest in the company. This plan is used by employers as an exit strategy from business ownership or to reward employees. Not only is it beneficial for the employees, but also for the company as they receive a lot of tax benefits with it.

Now, when a company offers an employee with equity compensation through an ESOP, the employee is getting only partial ownership of the company. And once the employee is granted ESOP shares, they do not own the shares instantly. The stock has to undergo a vesting period. This means that the employee has to work for the company for a certain period of time before they become the owner of the stocks offered through the ESOP program.

Vesting

Vesting, in simple words, means to earn an asset in the future after a certain period of time has passed and some conditions have been met according to the plan. With ESOP plans, employees do get the shares immediately when they are granted. They need to earn the shares overtime, after which they can exercise the vested stock options.

ESOP Vesting

Being an owner, you cannot just create a simple ESOP plan and grant your employees with your company’s shares instantly. What if the employee leaves without fulfilling the aim of the company? Well, in this case, ESOP vesting is very important. The owner has to create a proper ESOP plan and add in the rules that govern the operation of the plan.

And when making the rules, one of the main rules includes the ESOP vesting plan. The following will help you understand how to make it.

Vesting schedules

The first thing about ESOP vesting is the vesting schedule. The vesting schedule would help you accumulate the employee’s stake in the company and exercise more options over time.

In case an employee leaves the company before the shares are completely vested, they will retain their rights over the vested portion. The unvested shares would be canceled and returned to the unallocated ESOP pool of the company’s cap table. There are a lot of things that come under this as well including the cliff.

The Cliff

It is normal for the vesting schedule to have a cliff, where no stocks are vested in the first year. During this time, the companies get time to weed out the wrong hires without suffering from dilution.

The vesting schedule normally runs for 4 years (up to a max of 6 years). But the most popular vesting period lasts for 4 years, not just in the US, but in many other parts of the world where ESOPS are offered. The 4-year plan works as such: 25% of the shares are instantly vested after the cliff of a year, 50% of the shares are vested after 2 years, 75% after three years and 100% after four years. But, in the US, ESOP vesting is almost always monthly after the cliff for many tax reasons.

Back-Loaded ESOP Vesting Plan

In recent times, many alternatives to the traditional vesting model have come up, as the time-based formula has been criticized for emphasizing the closing of hires over longer-term retention. That is where the back-loaded ESOP vesting plan came into being.

As per this plan, instead of offering the employees a quarter of their shares in a year, the company can give the employees 10% in the first year, 20% in the second, 30% in the third and so on.

In short, you will have employees staying with your company for up to 10 years and longer. And this is a much better plan than having them stay for just 4 years or less. So, while you create your ESOP vesting plan for your company, consider this schedule and try to take advantage of it.

How does ESOP Vesting work?

Employers offer ESOPs and select a perfect vesting schedule to add to the ESOP plan. This schedule is outlined in the plan document, and if the employee leaves the company before all the shares are vested, they forfeit some of their shares. And the IRS requires companies to complete vest these shares no longer than six years, based on the kind of vesting.

As per Section 411 of the IRC (Internal Revenue Code), employers that are using the ESOP vesting can choose from two kinds of vesting schedules. One is graded vesting and the second is the cliff vesting. Under the graded vesting plan, employee shares are vested in even months over several years, but they have to be fully vested within 6 years. And under the cliff vesting plan, these shares vest all at once within no more than 3 years.

ESOP Distribution When An Employee is Terminated

ESOP benefits are mainly paid to participants when their employment with the company terminates, whether because of retirement or other reasons. As far as how soon the ESOP benefits are paid, there is a crucial distinction between retiring, death, or disability and simply leaving the company due to other reasons:

• When an ESOP participant’s employment terminates for reasons other than retirement, disability, or death, the distribution of his or her ESOP benefits can wait for a while. The participant must be given the right to start distributions no later than the sixth year after the year in which termination occurred. This is unless the participant is reemployed by the same company. Where the balance exceeds the plan’s cash-out provisions ($1,000 or $5,000), the participant may choose to defer distribution until normal retirement age or such other date provided in the plan.
• When an ESOP participant retires, becomes disabled, or dies, the ESOP must begin to distribute vested benefits during the plan year following the event, unless an exception applies.

But that is not all. Another reason why ESOP distributions might get delayed includes if the ESOP is leveraged. This means that if money is borrowed for the ESOP to purchase the shares of the company, the distributions of the ESOP acquired via the loan generally might be delayed after the plan year in which the loan is fully repaid. Nonetheless, this is not true for specific ESOP distributions following the retirement or death of the participant.

Nevertheless, this five-year period may be extended an additional year, up to a maximum of five additional years. That too, for each $210,000 or fraction thereof by which a participant’s benefit exceeds $1,050,000. Distributions are made in the form of cash or stock. These are the 2014 limits; they are adjusted annually.

Stocks Acquired before 1987

The rules shared above summarizes the special rules enacted for ESOPs in the Tax Reform Act of 1986. ESOPs acquired before 1987 may be distributed according to the rules governing qualified benefit plans in general. Depending on the circumstances, these rules often allow distributions to occur later than under the special ESOP rules. For instance, a participant may leave now but wait many years until he or she reaches retirement age to receive the pre-1987 stock.

ESOP Distribution When Employees are still Employed

There are special situations where the participants get benefits from an ESOP as they are still employed in the company. The situations include:

• The ESOP participants may “diversify” their accounts after a certain period and receive cash or stock directly.
• The employer may choose to pay dividends directly to ESOP participants on company stock allocated to their accounts.

The plan must generally begin distributing benefits to an ESOP participant who is a 5%-or-more owner after the participant reaches age 70 1/2, even if the participant is still employed. (Before 1997, this rule applied to all participants who had attained age 70 1/2.)

There are certain other circumstances in which the ESOP plan may provide for in-service distributions, such as after a fixed number of years, upon attainment of a specified age, or upon “hardship.”

Conclusion

When you are offering employee stock ownership plans to your employees, it is always better to have an ESOP vesting plan outlined. Ensure that the vesting plan benefits not just you, but the employee as well. And do not forget to make sure that the plan follows the rules set by the IRS.

While you set up your ESOP plans for your company, remember to keep track of all the shares well. The best way to do this is by using a cap table like Eqvista. You can easily create one here and prepare your ESOP vesting plan as well. And with this, you will be able to manage and track all the shares for your company.