Employee Stock Ownership Plans (ESOPs)

An employee benefit known as an employee stock ownership plan (ESOP) offers both new and current employees access to a portion of the company's shares. Learn more about ESOPs' advantages and disadvantages, as well as how ESOPs works.

What is an Employee Stock Ownership Plan (ESOP) ?

An employee stock ownership plan (ESOP) is a type of benefit plan that invests in company stock and distributes shares to its employees. It's a means to give stock in the company to employees without having to sell the company to a third party. In addition to serving as a sort of retirement plan, ESOPs also give employees income through the selling of their stock when they reach retirement age.

ESOP refers to an employee benefit plan which offers employees an ownership interest in the company. Employee stock ownership plans are given out as direct stock, profit-sharing plans, or bonuses, and it is entirely up to the business to decide who is eligible to participate. Employee stock ownership plans are merely options that could be bought at a certain price before the exercise date. Employers must abide by the guidelines and restrictions outlined in the Companies Rules when offering employee stock ownership plans to its staff members.

In the US, there are over 6,500 employee stock ownership schemes that cover 14 million workers. This is in addition to other types of employee ownership, such as stock options, direct purchase plans, and others.

Key Facts of Employee Stock Ownership Plan

  • ESOP is an employee benefit plan that gives workers ownership interest in the company in the form of shares of stock.
  • Since the shares can be sold for money when the employee retires, it can be utilized as a type of retirement plan.
  • Employee stock ownership plans motivate staff to work hard because they benefit financially when the business succeeds.
  • Most businesses link plan distributions to vesting, which gradually grants employees access to employer-provided assets.
  • It's crucial to study your ESOP's agreements because they may vary and contain different regulations.
  • Employees do not pay taxes on their ESOP shares until they are sold.
  • Companies with employee stock ownership plans are often linked to positive employee outcomes such as lower turnover.

How Does ESOP Work ?

ESOP is a retirement plan in which an employer contributes its stock to the plan for the benefit of the company’s employees. The workers allocates a certain percentage of the organizations stock shares to each eligible employee at no upfront cost. The allocation of shares may be made in accordance with the employee's pay scale, contract terms, or another basis.

Until an employee leaves the company or retires, the shares for an employee stock ownership plan are retained in a trust unit for security and growth. Following they departure, the corporation buys the shares back and distributes them to more employees. Employees typically need to be vested, which means they have a claim to those benefits, before they can access the funds in a company's stock ownership plan. Typically, employees are not eligible to participate in a company's stock ownership plan until they have worked a certain number of hours or years.

ESOP Up-Front Costs

Employees are frequently given this ownership by their employers with no upfront expenditures. Until the employee retires or quits, the corporation may place the issued shares in a trust for growth and protection. Distributions from the plan are frequently linked to vesting, which grants employees access to employer-provided assets over time. Typically, employees receive an increasing percentage of shares for each year of service.

The business "purchases" the vested shares back from a fully vested employee when they leave the company or retire. Depending on the plan, either a lump sum payment or equal monthly instalments are made to the employee. The corporation redistributes or cancels the shares after paying the employee and purchasing the shares. Only the cash reward is transferable to employees who leave the organization on their own volition.

Requirements for Employee Stock Ownership Plan

Employee stock ownership plans (ESOPs), which can be stock bonus plans or stock bonus/money purchase plans, are qualified defined contribution plans under IRC section 401(a). According to IRC section 4975(e)(8), an ESOP must be created with the intention of investing the majority of its funds in eligible employer equities and adhere to specific statutory and regulatory conditions. The IRS and Department of Labor share jurisdiction over some Employee Stock Ownership Plans features.

Who is Eligible for ESOP ?

Except for the promoters and directors of a company with more than 10% company stock, any employee is eligible for an Employee Stock Ownership Plans (ESOPs).

Types of ESOPs

Employee stock ownership plans are mainly categorized into five types :

1) Employee Stock Option Scheme (ESOS) :
Employee ownership in the form of stock options is fairly common. In this kind, you provide workers the choice to purchase business stock as a privilege rather than an obligation. By giving them the choice to purchase firm shares below their current market value, they achieve this. The option is subject to vesting, so you cannot exercise it until you have attained full vested status.

2) Employees Stock Purchase Plan (ESPP) :
ESPPs allow employees to receive a set number of shares in the business at a price below the stock's fair market value (FMV). The majority of ESPPs have a set lifespan. It stipulates that after purchasing shares, employees must hold onto them for a specific period of time. By issuing shares to employees through ESPPs, businesses can reduce their portion of the costs associated with an IPO.

3) Stock Appreciation Rights (SAR) :
Although SARs aren't strictly an ESOP plan, we can nevertheless use them as one. SARs give workers the chance to get paid based on the growth of the company's stock over a predetermined time frame. It gives employees equity without exposing them to any risk in the long run. Unlike other ESOPs, SARs do not offer the same tax advantages. However, they are advantageous to workers who have a long-term perspective on their business and desire to benefit from higher profits when the stock price increases.

4) Restricted Stock Units (RSU) :
Employee rewards based on performance under a particular company or total reward scheme are known as restricted stock units. Employees acquire shares under this kind of ESOP plan after meeting specific requirements.

5) Phantom Stocks :
Phantom stock is a form of long-term deferred compensation where an employee is given firm shares without the real stock being transferred. By aligning employees with owners, this kind of plans enables them to enjoy the same benefits without having to give up equity in the business. Phantom Stock is an abstract representation of the value of firm ownership. Phantom Stock can be used to monitor investor ownership levels but does not reflect shares that can be bought, sold, or exchanged.

Advantages of ESOP

1) Encourage an ownership mentality :
Plans for employee stock ownership allow employees to take pride in the company's accomplishments.

2) Linked to positive employee outcomes : 
Employee turnover and layoffs are less likely to occur at businesses with employee stock ownership plans, according to research.

3) Tax advantages for workers:
The tax benefit that employees receive from Employee Stock Ownership Plans is one of their advantages. The contributions made to an ESOP are tax-free for the employees. Only after retirement or when an employee leaves the company in another manner are employees subject to taxation.

4) Increased worker involvement :
Employers employing ESOPs typically see better levels of employee involvement and engagement. Employee awareness is raised as a result of their ability to shape decisions about goods and services. An ESOP also improves employee confidence in the business.

5) Positive outcomes for the business :
Employee stock ownership plans produce favorable results for the business as well as for the employees. A higher share price for the business and, ultimately, a higher balance in each employee's ESOP account result from superior organizational performance.

Disadvantages of ESOP

1) Lack of diversification :
Members of ESOP invest all of their retirement funds in a single business. The idea of investment theory, which encourages investors to invest in various businesses, markets, and places, is at odds with this lack of diversification.

2) Performance risk : 
Employees may lose stock and possibly face being let go if the company experiences setbacks or performs poorly.

3) Limited availability :
Employee stock ownership plans are only available for C-corporations and S-corporations.

4) Limits newer employees :
Early plan participants receive benefits from the ongoing contributions to the plan, which increases their voting power. The situation is different for fresher employees, who might not save as much as long-term employees even in solid organizations.

5) Dilutive :
An employee stock ownership plan dilutes shares, lowering the percentage of ownership that each share represents. Shares are assigned to new hires' accounts in the plan as they join the company. The overall percentage of shares held by older plan participants is decreased as a result.

How to Cash Out of an ESOP ?

Being vested does not automatically entitle you to an ESOP payout. Typically, you can only redeem these shares if you pass away, retire, lose your job, or become handicapped. Age is frequently a significant role. People under the age of 59½ or 55 are rarely allowed to receive distributions, and even then they may be subject to an early withdrawal penalty of 10%. The provisions set forth in the plan's guidelines contain detailed information on how to cash out of an ESOP.

You might be able to draw from your ESOP balance if you need money. Alternately, it is occasionally possible to withdraw dividend income or capital gains from rising stock prices.

How Does the ESOP Distribution Work ?

ESOP distributions are governed by the Internal Revenue Service (IRS). This implies that they must adhere to particular rules and fulfil particular requirements. A distribution policy, which may be found in the plan document or a different document devoted just to distribution, is a requirement for all ESOPs. The payout alternatives, lump sum thresholds, instalment payments, and vesting conditions will all be covered in this paper. Companies select the distribution method (shares, cash or both).

You must be vested in order to get your payout. Depending on the distribution rules of the plan, you can get your payout as a lump sum or as a series of payments. Depending on the current stock price, benefits are often given either as company shares or cash.

ESOP Withdrawal Rules

A simple definition of an ESOP distribution is the payment of rewards to eligible participants. There are numerous methods in which participants can be eligible for a distribution.
  • They are older than 59.5 and have retired from the company.
  • They have been terminated by the company or left and are over age 55.
  • They are continue working for the company but are over age 70 ½.

A participant may be eligible for "in-service" payouts in one of two conditions. When the participant is still employed by the company, an in-service distribution takes place. If a participant is over 55, has been a part of the plan for more than ten years, and qualifies for a diversification distribution, they may also be eligible for an in-service distribution.

ESOP Contact

The U.S. Department of Labor’s, Employee Benefits Security Administration oversees Employee Stock Ownership Plans (ESOPs). If you have a question about your ESOP, contact :
  • Toll-Free: 1-866-444-EBSA (3272)
  • Phone: (202) 219-8776

Frequently Asked Questions

What does ESOP Stand for?
Employee stock ownership plan is referred to as ESOP. An ESOP provides firm equity to employees, frequently depending on how long they have worked there. Usually, it's a component of a pay package, and shares will eventually vest. The goals and interests of employees and the shareholders of the company are matched thanks to ESOPs.

How the ESOP Payout Works?
The shares may be issued, paid for in cash, or paid for with both. If shares are issued, the employee has 60 days to sell the stock back to the company before it expires. You must give the employees stock certificates if they opt for stock distribution. Wherever stocks are traded, such as in a market or on the primary market following an IPO, employees may sell their shares. If they decide to pay cash, you can do it in one lump payment or over the course of two years.

What is an Example of ESOP?
Consider, worker who has five years of experience at a major software company. They are eligible for 20 shares after the first year and 100 shares altogether after five years under the company's ESOP. The value of the shares will be paid to the retiree in cash. Stock options, restricted shares, and stock appreciation rights are a few examples of equity ownership arrangements.

Who benefits from an ESOP?
Individual employees will immediately benefit from a company's success and will experience a feeling of ownership because an ESOP provides them a stake of the business. For businesses with employee stock plans, this might result in a rise in productivity and an improvement in overall performance. Employee stock ownership plans can be particularly beneficial for those who cannot afford a payroll deduction to a 401(k) plan.

Are ESOPs Beneficial to Employees?
Yes, ESOPs are typically regarded as a benefit for employees. Companies that don't routinely cut and replace personnel are more likely to implement these plans, which frequently result in higher payouts and financial incentives for employees.

Why Company offers an ESOPs to their employees?
Employee stock ownership plans are frequently used by businesses as a recruitment and retention strategy for top talent. Businesses that provide ESOPs have long-term goals. Companies want to keep their employees for a long time, but they also want to turn them into shareholders.

What is the difference between ESOP and a 401(k)?
While both the ESOP and the 401(k) are eligible retirement plans, the ESOP is supported completely by contributions of company stock, and the 401(k) is funded by the employee and occasionally matched by the employer. Because of this distinctive distinction, ESOPs are a fantastic choice for employees. Balances are typically 2.2 times greater with an employee stock ownership plan than with a 401(k). 6-8% of an employee's yearly pay might be contributed by the employer to an ESOP plan. Employees with 401(k) plans, however, often only contribute 4%.

Can my ESOP be rolled over into a 401(k) plan?
Rollovers from ESOP distributions are permitted into IRA and 401(k) plans. After a participant has attained the age of 55 and has taken part in the plan for at least 10 years, an ESOP may also be diversified.

What happens with the ESOP, when the employee quits?
Let's say a worker gets let go before reaching retirement age. In that situation, customers have the option of taking their vested retirement savings into a regular account or taking the funds in equal annual payments.

Can I take an early ESOP payout?
ESOP distributions are generally taxed as ordinary income, but if you are under 59½, the distribution is treated as an early withdrawal. Your ordinary income tax rate plus an extra 10% tax are applied to early withdrawals.

What is vesting period in employee stock ownership plans?
The time before employees fully own their stock options in an ESOP is known as the vesting period. Employers may mandate that workers stay with the company for a predetermined period of time before exercising their vested options in order to give workers a chance to develop a stake in their business. Companies that provide ESOPs to employees typically set the vesting periods. They frequently have an impact on the share price as well as other employment-related terms and conditions.

How long does it take to receive an ESOP distribution after leaving employment ?
The way you quit your job will determine when you receive your ESOP distribution. Payments under ESOPs must be made no later than a specific period after an employee departs the company. Start of distribution:
  • When a participant departs the company due to retirement, disability, or death, it is one year after the end of the plan year in question.
  • no later than six years following resignation or termination by the employer.