Benefits of Employee Stock Ownership Plans (ESOP)

An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that allows employees to own shares in the company they work for. This article provides an overview of what an ESOP is, its benefits for both employers and employees, and its treatment upon an employee’s retirement.

What is an ESOP?

An ESOP is a type of qualified retirement plan designed to invest primarily in the stock of the sponsoring employer. It provides employees with an ownership interest in the company, aligning their interests with those of the company’s shareholders. ESOPs are often used by the sponsoring company as a corporate finance strategy to both align employees with company goals and to facilitate a succession plan. An ESOP may be funded by a company by putting newly issued company shares into the plan or by contributing cash to purchase existing company shares. 

Benefits of an Employee Stock Ownership Plan

For Employers:

1. Tax Advantages: Contributions of stock or cash to an ESOP are tax-deductible by the company. Also, when companies use a leveraged ESOP to borrow money, they can repay the loan with pre-tax dollars. These tax advantages help improve the company’s cash flow.
2. Employee Motivation: By providing employees with a stake in the company, an ESOP can boost morale and productivity, as employees directly benefit from the company’s success.
3. Retention and Recruitment: ESOPs can be an attractive benefit that helps in retaining and recruiting talented employees.
4. Succession Planning: For closely held companies, ESOPs offer a way for owners to sell their shares and transition ownership without selling to outside parties. ESOPs provide a market for the stock of major shareholders and their estates where the company can contribute pre-tax dollars to the plan to buy shares of company stock.

For Employees:

1. Retirement Savings: Contributions are typically made by the employer as a part of an employee’s overall benefits. As contributions occur and the value of the company stock increases, employees may build substantial retirement savings in an ESOP, in addition to what they may have within a company 401(k) plan.
2. Ownership Stake: Employees gain a sense of ownership in the company, which can enhance job satisfaction and loyalty.
3. Tax Benefits: Employees typically do not pay taxes on the ESOP shares until they receive distributions, usually upon retirement or leaving the company.

Treatment of ESOP at Retirement

Each company’s ESOP is uniquely designed and an employee’s shares’ treatment at retirement may vary from one plan to another.

1. Distribution of Shares: An employee is entitled to receive their vested shares in the ESOP at retirement. They can receive this as a distribution in the form of company stock or cash equivalent, depending on the plan’s terms. However, there are age restrictions on distributions which are defined in the ESOP’s summary plan description. Usually, if an employee retires at the plan’s normal retirement age (typically age 65), distributions begin within a year of retirement. If the employee retires before the plan’s normal retirement age, distributions can be delayed. ESOPs also must follow required minimum distribution rules, even if the employee is still working at the company.
2. Valuation: The value of the shares is determined based on the fair market value at the time of distribution. For closely held businesses, a valuation is required before a distribution is made. This can cause a delay between retirement and distributions.
3. Payout Options: ESOPs often provide different payout options, such as lump-sum payments, periodic installments, or rollovers. The choice of payout method can have tax implications and affect retirement income planning.
4. Taxation: Distributions from an ESOP may be subject to tax. If the employee takes a lump-sum distribution or periodic payments, the distribution is taxed as ordinary income. However, an employee may have the option to roll over the distribution into an IRA or another qualified retirement plan to defer taxes. It is important to note that shares distributed from an ESOP may be eligible for Net Unrealized Appreciation (NUA) treatment.

A careful consideration of distribution options is required to make the most appropriate selection based on the ESOP’s options and the employee’s personal financial situation. We recommend consulting with your wealth manager and tax advisor before making an election on how to receive your ESOP distribution at retirement.

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