What Is an ESOP and How Does an ESOP Work?

7 minute read

An ESOP, also known as an Employee Stock Ownership Plan, is a way for employers to give their employees the benefit of ownership interest in the company in the form of stock. This strategy can help align the interests of employees with existing shareholders. We’ll dive deeper into what is an ESOP below, along with how an ESOP works.

ESOPs Explained

An ESOP gives employees company stock, usually based on the duration of their employment. This can facilitate succession planning, but it also encourages employees to always do what’s best for the company since they own stock in it.

In this way, company shareholders are closely aligned with employees on helping the company grow moving forward. In addition, ESOPs provide tremendous tax benefits, which is another reason company owners initiate ESOP plans.

How Does an ESOP Work?

An ESOP is set up like a trust fund. A company can place newly issued shares or fund the trust with cash to buy shares. A company’s employees are then given the right to a growing number of shares. The number of shares rises over time, usually dependent on how long the employment term is. 

This allows longer-term employees to benefit more than employees who decide to pursue employment elsewhere, making ESOPs a great employee retention tool. The longer a worker stays, the more they are rewarded in company stock.

How and when do employees benefit from all this company stock? Typically, shares are sold at the time of retirement or whenever the employee quits or is terminated. For however many shares the employee has, they are remunerated with the cash value of their company shares.

What Happens to ESOP If You Quit?

Employees who quit will lose any shares that are not vested. ESOPs typically tie the distributions to some sort of vesting schedule to avoid companies having to give a large amount of shares to an employee who didn’t stay long. Each year, more and and more shares become available so that the employee’s stock grows over time, keeping them vested in the company. Managers can continually remind workers to focus on corporate performance, since they are also financially attached to the share price.

This puts the employee’s motivations on the same page as the company’s interests. A worker knows that the more they can help the company, the more valuable their stock will be. All in all, it can often be a win-win situation for both employers and employees.

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ESOPs in Action

An example of an ESOP might look like this: employees have the right to receive 10 shares every year, with an additional bonus of 25 shares at the fifth year. So, an employee who has been at the company for three years would have 30 shares, and an employee at five years would have 75 shares. 

If both those employees retire, they’d each receive their particular share of value in cash. Keep in mind that stock ownership could also include stock options, restricted shares and stock appreciation rights.

How Is an ESOP Taxed When Distributed?

The good news is that employees don’t pay tax on stock allocated to their ESOP account until they receive distributions. Of course, upon distribution, there are taxes. If the money is rolled into an IRA, the employee pays no tax on it until it is withdrawn. 

If an ESOP pays dividends directly to a participant, then the dividends are not subject to excise tax of early distributions. They would also be exempt from income tax withholding. However, dividend payments remain taxable.

In cases where an ESOP distributes shares of a company stock rather than paying the value in cash, the employee must pay income tax at the ordinary rate on the value of company contributions to the plan, plus capital gains tax when they sell their shares.

Negatives of ESOPs

While there are many potential benefits of an ESOP, there are potential downsides as well. For starters, they require ongoing administration. Whether it’s annual valuation and plan administration to legal fees, these can get expensive.

Secondly, shareholders may not maximize the proceeds from a sale with an ESOP. This is because an ESOP is a financial buyer and not a strategic buyer. What this means is that it only pays fair market value to the current owner — it doesn’t pay a premium where current ownership receives top dollar. 

Lastly, ESOPs may not be ideal for small businesses or startups. This is because an ESOP can only be used with C corporations or S corporations. So, many LLCs, partnerships and sole proprietors are already left out. For some smaller corporations, it may be financially difficult if several team members leave around the same time, which would cause a steep expense when they depart since shares must be repurchased. 

Many small businesses might prefer to reinvest in their business operations rather than move cash flow into starting and maintaining an ESOP.

Positives of ESOPs

As mentioned earlier, there are several positives of having an ESOP:

  • ESOP shares can make employees feel invested in the company’s success and motivated to stay with the firm.
  • There are tax benefits, since ESOPs are tax-exempt trusts. 
  • Profits earned by the company can stay with the employees. 
  • An ESOP allows for gradual ownership transition. This is helpful if the company wants to gradually shift ownership between partners over time rather than all at once.

How to Create an ESOP

To create an ESOP, a company must establish a trust to buy back stock. Each year, the company will either need to make tax-deductible contributions of company shares or cash for the ESOP to buy company shares — or both. Every single year, the ESOP will own stock and add shares into the accounts of employees.

Before an ESOP is set up, however, all owners need to be on board with it. Secondly, you’ll need to do a valuation. If the value is too low, the company owners will get a bad deal. If too high, the company may not be able to afford it. This is why a valuation consultant is likely needed — they can look at the cash flow, profits, market conditions, assets and more to determine a good valuation.

Once a valuation is set up, it’s wise to hire an ESOP attorney. Last, but not least, the company of course will need to fund the ESOP and operate it. All in all, ESOPs are very doable but they are far from simple.

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