How an ESOP Works
Invest in Your Employees
and Your Business with an ESOP
As of 2022, the National Center for Employee Ownership (NCEO) estimates roughly 6,500 ESOPs covering almost 14 million participants.
What is an ESOP
An ESOP is a retirement plan designed to provide employees with company ownership interest by investing primarily in the employer's stock. It is not like other retirement plans, which usually diversify holdings by investing in various assets.
Who Funds an ESOP
The employer funds the ESOP with tax-deductible contributions to purchase company shares. It operates through a trust under the direction of a trustee or another named fiduciary. An ESOP must comply with the requirements set forth by the Internal Revenue Service (IRS).
Why Companies Choose Employee Ownership
When evaluating your options for exiting or achieving liquidity from your business, you will face many choices. Although the most traditional method of selling a privately held company is a sale to an unrelated third party, business owners often seek to keep their business in the family or sell to management. However, not all family members have the desire or ability to take over, and management may not have the means to purchase it. In addition, an owner may seek out an ownership exit strategy that allows the owner to retain the legacy of the business, maintain the company within the local community, and permit the owner to stay involved following a change in ownership. ESOPs are an alternative approach, gaining widespread appeal as more companies recognize the unique and flexible ownership benefits.
How an ESOP Works
A company establishes an employee stock ownership trust and makes yearly contributions to the trust. These contributions are either in new or treasury stock, cash to buy existing shareholder stock or pay-down debt used to acquire company stock. Regardless of the form, the contributions are tax-deductible.
Employees or ESOP participants have accounts within the ESOP to which stock is allocated. Typically, the participant’s stock is acquired by contributions from the company – the employees do not buy the stock with payroll deductions or make any personal contribution to acquire the stock. Plan participants generally accumulate account balances and begin the vesting process after one year of full time service. Contributions, either in cash or stock, accumulate in the ESOP until an employee quits, dies, is terminated, or retires. Distributions may be made in a lump sum or installments and may be immediate or deferred.
When Do Employees Receive ESOP Benefits
ESOP distributions are paid out when employees leave the company. This can be in a lump sum payment or in substantially equal annual payments over a period of not more than five years. Employees meeting certain requirements for age and plan participation may choose to take limited distributions for diversification purposes before leaving the company. These diversification rights begin at age 55 for employees with 10 years or more of employment with the ESOP.
Participants not subject to required minimum distributions (RMDs) who receive ESOP distributions can choose a rollover to another qualified plan to defer taxation until the money is withdrawn in retirement.
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