Many employees find more satisfaction in working hard for their employer if they have an ownership stake in the company. An ESOP, or employee stock option plan, is one way to achieve this, making it easy for employees of privately held companies to have part-ownership in their employer’s company or be given partial ownership as a reward for their efforts.
An ESOP is a qualified retirement plan that lets employees have ownership in the company that employs them. Stock in the plan can be purchased directly by an employee or received through profit sharing. The stock may also be given in the form of stock options, or granted as a bonus.
ESOPs are usually set up to provide privately held company owners with a market for the shares they own in their own company, to reward and motivate employees and to receive tax incentives for borrowing funds to help employees purchase shares. The ESOP plan serves as a contribution to employees rather than an expense.
Taking money out of an ESOP is like withdrawing money from any other qualified retirement plan. The plan assumes the money will stay in, unless the person chooses to withdraw it. The rules regarding distributions of a vested balance in an ESOP account vary based on the specific rules set up by the company. The rules are contained in the ESOP’s plan summary. The plan administrator can provide a copy.
Employees are subject to vesting periods before they have full ownership of their shares of stock in an ESOP. If the shares are not vested, the employee will not be able to receive any payout, and if the employee leaves the company before his vesting period is up, he forfeits ownership of his ESOP shares altogether.
Distributions that allow employees to diversify their investment are required to be handled by the ESOP in a few different ways. Employees who have participated in the ESOP for 10 or more years may withdraw up to 25 percent of their shares within a five-year period or up to 50 percent of the shares within six years. The proceeds can be invested in independent retirement vehicles or other investments outside of the ESOP.
An employee may direct his employer to roll over his vested balance in the ESOP into an individual retirement account, or have the funds sent to the employee directly. In this case, the employer must withhold 20 percent of the balance and send it to the Internal Revenue Service.
Retirement, Disability or Death
ESOPs are legally required to pay participants a benefit one year after the employee is separated from the company, but the company may not force a participant to take distributions until he reaches retirement age. If an employee does not retire from the company, the plan must begin distributing to him on April 1 of the year immediately after the employee reaches 70 ½. The rules become somewhat complex if an employee retires or dies, and the payout timing depends on whether the loan to purchase the shares has been repaid. In most cases, the plan must pay out within five years to the employee or a designated beneficiary, regardless of the loan repayment status.
- The National Center for Employee Ownership; The ESOP Participant's Guide to ESOP Distribution Rules
- The National Center for Employee Ownership; How an Employee Stock Ownership Plan (ESOP) Works
- Internal Revenue Service. "4.72.4 Employee Stock Ownership Plans (ESOPs)." Accessed Oct. 19, 2020.
- United States Code. "From Title 26-Internal Revenue Code, Subtitle A-Income Taxes, Chapter 1-Normal Taxes and Surtaxes, Subchapter O-Gain or Loss on Disposition of Property, Part III-Common Nontaxable Exchanges, §1042. Sales of Stock to Employee Stock Ownership Plans or Certain Cooperatives." Accessed Oct. 19, 2020.
Cynthia Gaffney has spent over 20 years in finance with experience in valuation, corporate financial planning, mergers & acquisitions consulting and small business ownership. She has worked as a financial writer and editor for several online finance and small business publications since 2011, including AZCentral.com's Small Business section, The Balance.com, Chron.com's Small Business section, and LegalBeagle.com. A Southern California native, Cynthia received her Bachelor of Science degree in finance and business economics from USC.