Employee Stock Ownership Plans | A Brief Overview

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Jason B. Freeman

Jason B. Freeman

Managing Member


Mr. Freeman is the founding member of Freeman Law, PLLC. He is a dual-credentialed attorney-CPA, author, law professor, and trial attorney.

Mr. Freeman has been named by Chambers & Partners as among the leading tax and litigation attorneys in the United States and to U.S. News and World Report’s Best Lawyers in America list. He is a former recipient of the American Bar Association’s “On the Rise – Top 40 Young Lawyers” in America award. Mr. Freeman was named the “Leading Tax Controversy Litigation Attorney of the Year” for the State of Texas for 2019 and 2020 by AI.

Mr. Freeman has been recognized multiple times by D Magazine, a D Magazine Partner service, as one of the Best Lawyers in Dallas, and as a Super Lawyer by Super Lawyers, a Thomson Reuters service. He has previously been recognized by Super Lawyers as a Top 100 Up-And-Coming Attorney in Texas.

Mr. Freeman currently serves as the chairman of the Texas Society of CPAs (TXCPA). He is a former chairman of the Dallas Society of CPAs (TXCPA-Dallas). Mr. Freeman also served multiple terms as the President of the North Texas chapter of the American Academy of Attorney-CPAs. He has been previously recognized as the Young CPA of the Year in the State of Texas (an award given to only one CPA in the state of Texas under 40).

Since their establishment in 1974, Employee Stock Ownership Plans (“ESOPs”) have become a popular and effective mechanism for private companies (both C corporations and S corporations) to provide employees an opportunity to share in the potential growth of their employer’s stock, as well as help the company with its business.

ESOPs provide several important benefits.  ESOPs can assist with succession planning for owners of private companies who want to transition flexibly out of their business and wish to sell their shares using this method.  ESOPs also enable companies to align the interests of their employees’ financial wellbeing with the interests of stockholders.

So far, more than 6,500 ESOP plans have been created that involve over 14.7 million people, according to the most recent data.  These plans hold assets of over $2.1 trillion.  While ESOPs may be less flexible than stock options, they assist with keeping employees vested in their company, and also provide incentives for better productivity, offer certain tax advantages, and promote higher job satisfaction.

What to Know About ESOP

Regulated by the Employee Retirement Income Security Act (ERISA), ESOPs are tax-qualified benefit plans that have minimum standards for investment plans in private industry. ESOPs are authorized by the Internal Revenue Service (IRS) and are supervised by the Department of Labor (DOL).  Section 404(a)(3) of the Internal Revenue Code (IRC), which describes certain tax-qualified retirement plans, includes ESOPs. The IRC provides for certain amounts of deductible contributions an employer can make to a tax-qualified stock bonus or profit-sharing plan of 25% of the compensation.

For a private company, ESOPs serve a myriad of functions, both for the company and its employees. These include, but are not limited to, the following abilities:

Perhaps most importantly, ESOPs provide employees an opportunity to hold an ownership stake in the company.  Under an ESOP, company shares are allocated to employees, much like a profit-sharing plan. However, ESOPs differ from most employee retirement plans in the following ways:

In order to be eligible for participation in an ESOP, an employee must (i) be at least 21 years of age and (ii) have been employed for at least 120 days, or 1,000 hours, in a plan year. Once eligibility is established, an employee can become a participant at the end of the month in which they become eligible. Qualified employees will be able to receive a contribution to their ESOP account at the end of the fiscal year. This contribution is calculated as a percentage of total annual compensation and applies to all participants.

If an employee has a complaint regarding an ESOP, they can file the claim at the Employment Benefits Security Administration (EBSA).

How Do ESOPs work?

When a company offers an ESOP, it first establishes a trust fund. To fund it, the company can either (i) contribute cash to buy shares of stock from existing owners (at no more than fair market value), or (ii) issue new shares.  If the company does not have the cash to do this immediately, the ESOP can take out a loan to buy new or existing shares while the company contributes money to pay off the loan.

The employer also determines the number of shares before allocating them to an individual eligible employee account, which is usually distributed following their relative pay. As an employee works for the company for a more extended period, their right to the allocated shares increases—a process known as “vesting.”  Vesting is classified into two categories:

Employees eventually own either a part or the entire company, depending on their plan. As an added benefit, the vesting and ownership of shares also grants employees some manner of control and voting rights in the company.

When an employee leaves the company, the company may buy back the employee’s shares of stock at fair market value, unless the shares are publicly traded. As a result, the employee receives the value of their shares from the trust, usually in the form of cash. ESOPs have different types of stock distributions based on the type of plan: non-leveraged stock, leveraged stock, stock election, or the put option.

H2: Taxation of ESOPs

Some key, attractive features of ESOPs are their tax benefits for the employee and employer company.

For corporations, the financing aspect of ESOPs enable them to refinance corporate debt for greater cash flow. Traditional loans require repayment of the principal with after-tax dollars, whereas ESOP-financing enhances the ability of the sponsoring corporation to meet debt service requirements pre-tax, and are tax deductible under section 404(a). For an S corporation that is owned by an ESOP, the S corporation’s income will generally be exempt from federal income tax at either the corporate or shareholder level and not required to make distributions, especially if it’s 100% owned by an ESOP. For a C corporation, certain requirements must be satisfied to minimize taxes. If the C corporation’s stock is sold to an ESOP in such a way that would normally be qualified as a long-term capital gain, the shareholder selling the stock would pay no tax at the time of sale on all or part of the realized gain. Dividends paid to an ESOP may be tax deductible by the C corporation, and the C corporation can deduct loan repayments on an ESOP loan.

For employees, they may receive tax-deferral treatment under an ESOP.  Employees are not taxed on the stock allocated to their ESOP accounts, and are not required to pay tax until they receive cash distributions.  However, employees with an ESOP under the age of 59 and a half years (or 55 if they have terminated employment) will be subject to applicable taxes as well as an additional 10% excise tax on early distributions.  This can be avoided by “rolling” the money (i.e., transferring it) into an Individual Retirement Account (IRA). The employee can also transfer the money into a successor plan in another company, unless the participant terminated employment due to death or disability. If the funds are rolled over into an IRA or successor plan, the employee pays no tax on them until they are withdrawn, at which point they are taxed as ordinary income. Rollovers from ESOP distributions to IRAs are permitted for stock or cash distributions made in less than ten years.