Daniel Laure, CFP®, MBA, RICP®
February 4, 2022
A company that wants to supplement its employees’ salary with equity compensation can do so in a variety of ways. The most popular is the employee stock ownership plan (ESOP). Besides offering employees a potentially valuable ownership stake in the company, ESOPs can play an important role in succession planning and confer tax advantages to employers.
What is an employee stock ownership plan?
An ESOP is essentially a trust fund. A company can deposit newly issued shares into the fund, as well as money used to buy existing shares. Employees participating in the ESOP each receive accounts. While keeping shares inside the trust, the ESOP allocates them to employees based on a formula that may take pay level and seniority into account.
These shares may “vest” over time, meaning that employees have to work with the company for several years before acquiring shares, and they may own more shares the longer they work. Any dividends paid directly to shareholders are tax-deductible for the employer and taxed as income for the shareholder.
ESOP rules ensure that employees have equal access to the plan and are treated fairly. With few exceptions, an ESOP must be open to all full-time employees over the age of 21. Employees must gain voting rights equal to the number of shares they own on some or all company issues.
When an employee leaves their job, the ESOP buys back all of their shares at market value, meaning they walk away with a cash payout equal to the value of the shares they own. This payout can come as a lump sum or as a series of substantially equal payments over a period of time. If the employee leaves before the vesting period has ended, they forfeit any unvested shares.
When an individual cashes out their ESOP shares, they pay ordinary income tax on the distribution(s) they receive. If under age 55, they’ll be charged an additional 10% excise tax unless they roll over their ESOP balance to a tax-advantaged retirement account, such as an IRA or 401(k).
Benefits of an ESOP
Some people advocate ESOPs because they have an ideological commitment to employee ownership. Outside of this, ESOPs have several specific advantages:
As a retirement benefit, ESOPs are virtually unique in asking for no employee contribution in most cases. As a buyer for an outgoing owner’s shares, ESOPs can keep businesses afloat that might otherwise have folded. As a financing tool, ESOPs offer tax-deductible borrowing.
Establishing an ESOP is a multistep process that includes a feasibility study, a valuation of the business, and the help of an attorney in drafting the plan, but depending on the needs of the business, it can be a powerful, multiuse tool.
This blog post is written by an unaffiliated third-party, and as such, the opinions and views expressed are not necessarily those of Visionary Wealth Advisors. This material is intended for general information only and should not be construed as personalized investment, legal, or tax advice. The information is based on sources believed to be reliable; however, its accuracy or completeness cannot be guaranteed. Statements made in this blog may be subject to change depending on revisions to the tax code, statutes, regulations, or government policy. Please consult your accountant, attorney, or financial advisor prior to engaging in any legal, investment, or tax strategy.