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ESOPs: How They Function and How They Are Structured

Feb 19, 2024

Employee stock ownership plans (“ESOPs”) are an increasingly popular employee benefit these days. This is not surprising, as ESOPs offer many benefits to corporations and their employees. By having an ESOP, employers can offer employees a share in the ownership of a company, which provides an added benefit or incentive of working and doing well at a company.

ESOPs Explained

Most companies offer their employees some type of defined contribution plan – that is, a retirement plan that employees contribute amounts to over the years. ESOPs are one type of employee benefit plan that allows employees to own part or all of the company that employs them through purchasing shares of stock or employer securities.

An ESOP is functionally similar to a 401(k), in that it buys and holds shares of stock for benefit of individual employees in individual retirement accounts. ESOPs, however, are required to invest in the stock of the employer (also called the “ESOP sponsor” or the “sponsoring employer”) as opposed to investing in a diversified portfolio. ESOP trustees still have a fiduciary duty to safeguard the retirement benefits of the employees. Like other qualified retirement plans, ESOPs are regulated under both the Employee Retirement Income Security Act (“ERISA”) and the Internal Revenue Code (“IRC”). Additionally, the rules relating to qualified plans under IRC Sec. 401(a) apply to ESOPs.

The ESOP can be funded with newly created shares of the company’s stock or cash to buy already existing shares; or via a loan to buy new or existing company stock. The shares are held by the ESOP in trust for individual employee accounts, much like a 401(k). As the ESOP trust holds the company’s stock, it is the beneficial owner of the company. ESOPs can borrow funds from the employer, its shareholders, or third parties to buy the employer’s shares of stock. The sale of those securities by the company to the ESOP is exempt from the ERISA prohibited transaction rules, provided that certain requirements are met. 

How Participants Receive ESOP Shares 

ESOP shares are usually part of an overall compensation package for employees. ESOP shares are typically allocated to participants based on how much they earn. The shares are allocated proportionally across employees based on their compensation, which results in higher paid employees receiving higher percentages than lower paid employees. Thus, an employee making $100,000 per year will get more shares than an employee who is making $80,000 per year.

The employee will defer the inclusion of income and will not pay taxes on the shares that are contributed to the ESOP until the employee takes a distribution of their account balance. Upon termination or retirement, many plans allow the participants to sell their shares back to the plan and the participant can roll their balance to an IRA or another qualified plan as they can with a traditional retirement plan.

Employees usually vest in their shares over time, using either cliff vesting or graded vesting. Cliff vesting is when employees have zero vested interest in their account until they have been employed for a certain amount of time, at which point they vest in the full amount. The second vesting provision is graded vesting, in which a defined amount is vested every year for a set amount of time (e.g., 25% vesting every year until the participant is fully vested after four years).

Two Common ESOPs 

Not all ESOPs are structured in the same way. There are two common ways to structure these plans: Leveraged and nonleveraged.

Leveraged ESOPs

A leveraged ESOP borrows money directly from either the employer, the selling shareholder(s), a bank, or some other type of financial institution to purchase the company stock. The ESOP sponsor must use a loan agreement to borrow the funds from a third-party lender or the selling shareholder(s). The ESOP sponsor then loans the proceeds to the ESOP. The ESOP sponsor may either be a publicly traded company or a privately held company whose shares are not publicly traded and may be formed as either a C corporation or an S corporation. Partnerships and sole proprietors are not able to take advantage of ESOPs.

When an ESOP borrows money, the only assets that can be used as collateral are the employer securities that are being purchased. If an employer loans money directly to the ESOP, the employer must still make a contribution to the plan for the plan trustee to repay the principal and interest on the loan.

Selling shareholders are paid the fair market value (“FMV”) and can potentially defer or eliminate any taxes associated with their gains. Additionally, the sponsor company can take an income tax deduction as contributions are made to the plan to pay off the loan. In the event an employee leaves a company, the employee is paid out for the shares that the leaving employee owns, either in a lump sum or over a period of years.

Nonleveraged ESOPs

The nonleveraged ESOP, however, does not involve borrowed funds (i.e., debt) to acquire the sponsoring employer’s stock. Instead, the sponsoring employer directly contributes cash or treasury stock to buy stock from the company or from existing owners. A nonleveraged ESOP (which is technically not an ESOP under the Code) may sometimes be referred to as a stock bonus plan.

The sponsoring employer can contribute stock and take a deduction for the fair market value of the shares, or the cash, it contributes to the plan. When cash is contributed to the ESOP, the ESOP will use that money to purchase the employer’s stock from the selling shareholders and the stock is then allocated to the ESOP participants. Alternatively, the employer may also contribute its stock directly to the ESOP. When stock is contributed to the ESOP, then the stock will also be allocated to the ESOP participants.

Companies may first implement a nonleveraged ESOP plan, where the ownership percentage of the company owned by the ESOP grows on a gradual basis, and then change to a leveraged ESOP for subsequent transactions. In both leveraged ESOPs and nonleveraged ESOPs, the employees receive the benefits from the shares as the beneficial owners of the shares.

The fact that an ESOP can be structured to provide employee retirement benefits and shareholder liquidity, and to promote employee ownership, makes it an attractive and multi-faceted option for employers to offer their employees. Taxpayers who believe they could benefit from an ESOP should reach out to a trusted tax advisor to help them determine the best structure for their company.

This is the first or a multi-part series on employee stock ownership plans. To learn more, see:

 The Tax Benefits of an ESOP

How ESOPs Can Help Cannabis Operators

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