By AKHILESH GANTI Updated July 20, 2022
Reviewed by SAMANTHA SILBERSTEIN
Fact checked by PATRICE WILLIAMS
Link to original article: INVESTOPEDIA
What Is an Employee Stock Ownership Plan (ESOP)?
An 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. ESOPs give the sponsoring company—the selling shareholder—and participants various tax benefits, making them qualified plans, and are often used by employers as a corporate finance strategy to align the interests of their employees with those of their shareholders.
How Does an ESOP Work?
An ESOP is usually formed to facilitate succession planning in a closely held company by allowing employees the opportunity to buy shares of the corporate stock.
ESOPs are set up as trust funds and can be funded by companies putting newly issued shares into them, putting cash in to buy existing company shares, or borrowing money through the entity to buy company shares. ESOPs are used by companies of all sizes, including a number of large publicly traded corporations.
Contrary to what some people say, companies with an ESOP must not discriminate and are required to appoint a trustee to act as the plan fiduciary. Among other things, it is not possible for senior employees to receive more shares or for ESOP participants to have no voting rights.
Advantages of ESOPs
Since ESOP shares are part of the employees’ remuneration package, companies can use ESOPs to keep plan participants focused on corporate performance and share price appreciation. By giving plan participants an interest in seeing the company’s stock perform well, these plans supposedly encourage participants to do what’s best for shareholders, since the participants themselves are shareholders.
Employees, meanwhile, are presented with a way to make more money, increase their compensation, and essentially be rewarded for their hard work and commitment. Having a stake in the company should make employees feel more appreciated and perhaps make going to work more exciting.
ESOP Up-front Costs and Distributions
Companies often provide employees with such ownership with no up-front costs. The company may hold the provided shares in a trust for safety and growth until the employee retires or resigns.
Companies typically tie distributions from the plan to vesting, which gives employees rights to employer-provided assets over time; typically, they earn an increasing proportion of shares for each year of their service.
When a fully vested employee retires or resigns from the company, the firm “purchases” the vested shares back from them. The money goes to the employee in a lump sum or equal periodic payments, depending on the plan.
Once the company purchases the shares and pays the employee, the company redistributes or voids the shares. Employees who leave the company voluntarily cannot take the shares of stock with them, only the cash payment.
How to Cash Out of an ESOP
Being vested doesn’t necessarily mean you can cash out of your ESOP. Generally, it’s only possible to redeem these shares if you terminate employment, retire, die, or become disabled.
Age is often an important factor. Distributions are rarely permitted to people under 59½—or 55 if terminated—and, if they are allowed, they could be subject to a 10% early withdrawal penalty. Specific information about how to cash out of an ESOP can be found in the terms listed in the plan’s guidelines.
TIP: If you need money, you may be able to borrow from your ESOP balance. Alternatively, it is sometimes possible to withdraw dividend proceeds or money earned by increases in stock prices.
ESOP and Other Forms of Employee Ownership
Stock ownership plans provide packages that act as additional employee benefits and embody the corporate culture that company managements want to maintain. Other versions of employee ownership include direct-purchase programs, stock options, restricted stock, phantom stock, and stock appreciation rights.
Direct stock purchase plan (DSPP) lets employees purchase shares of their respective companies with their personal after-tax money. Some countries provide special tax-qualified plans that let employees purchase company stock at discounted prices.
Restricted stock gives employees the right to receive shares as a gift or a purchased item after meeting particular restrictions, such as working for a specific period or hitting specific performance targets.
Stock options provide employees the opportunity to buy shares at a fixed price for a set period.
Phantom stock provides cash bonuses for good employee performance. These bonuses equate to the value of a particular number of shares.
Stock appreciation rights give employees the right to raise the value of an assigned number of shares. Companies usually pay these shares in cash.
What does ESOP stand for?
ESOP stands for employee stock ownership plan. An ESOP grants company stock to employees, often based on the duration of their employment. Typically, it is part of a compensation package, where shares will vest over a period of time. ESOPs are designed so that employees’ motivations and interests are aligned with those of the company’s shareholders. From a management perspective, ESOPs have certain tax advantages, along with incentivizing employees to focus on company performance.
How does an ESOP work?
First, an ESOP is set up as a trust fund. Here, companies may place newly issued shares, borrow money to buy company shares, or fund the trust with cash to purchase company shares. Meanwhile, employees can accumulate a growing number of shares, an amount that can rise over time depending on their employment term. These shares are meant to be sold only at or after the time of retirement or termination, and the employee is remunerated by receiving the cash value of their shares.
What is an example of an ESOP?
Consider an employee who has worked at a large tech firm for five years. Under the company’s ESOP, they have the right to receive 20 shares after the first year, and 100 shares total after five years. When the employee retires, they will receive the share value in cash. Stock ownership plans may include stock options, restricted shares, and stock appreciation rights, among others.
Are ESOPs good for employees?
Yes, ESOPs can generally be considered a benefit for workers. These programs tend to be adopted by companies that don’t chop and change staff frequently and often result in a bigger payout and greater financial compensation for employees.
The Bottom Line
ESOPs are generally a win-win for employers and employees, encouraging greater effort and commitment in exchange for bigger financial rewards. However, they are not always straightforward and can be frustrating if the participant doesn’t fully understand the terms of their particular plan.
Not all ESOPs are the same. Rules on actions such as vesting and withdrawals can vary, and it’s important to be aware of them to make the most of this benefit and not potentially miss out on a big extra bonus.
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National Center for Employee Ownership. “How an Employee Stock Ownership Plan (ESOP) Works.”
Internal Revenue Service. “Chapter 8: Employee Stock Ownership Plans (ESOPs), Including S Corporation ESOPs and Anti Abuse Measures.”
Internal Revenue Service. “Retirement Topics — Vesting.”
Internal Revenue Service. “Retirement Topics — Exceptions to Tax on Early Distributions.”
U.S. House of Representatives, United States Code, Office of the Law Revision Counsel. “26 USC 401: Qualified Pension, Profit-sharing, and Stock Bonus Plans.”
Internal Revenue Service. “Chapter 8: Examining Employee Stock Ownership Plans (ESOPs), Including New Developments,” Page 26.