What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is an employee benefit plan that enables employees to have ownership interest in the company.

It is a qualified defined contribution plan that is either a stock bonus plan or a combination stock bonus and money purchase plan that invests primarily in the employer’s securities.

Generally, this is common stock issued by the employer that is traded on an established securities market. An ESOP may use employer contributions to buy common stock from the controlling stockholders if the price reflects the value of the stock in the open market.

Key Aspects of ESOPs

One of the key aspects of an ESOP is its ability to borrow to acquire employer securities—a so-called exempt loan—and its ability to use plan assets to repay an exempt loan. Participants in an ESOP are entitled to direct the plan as to how they want to vote the securities that have been allocated to their account.

Another important feature of these plans is the employee’s right to direct at least 25% of the account balance to other investments after they reach age 55 and have been a plan participant for at least 10 years.

This “diversification of investments” election permits older employees to select investments suitable for their anticipated retirement.

If the ESOP is part of a larger plan, like a profit sharing plan that permits employee contributions, employees may be able to divest the employer stock and allocate it to other plan investments once the individual has completed three years of service as a participant.

ESOP benefit payments must begin:

  • As the result of retirement or disability: No later than one year after the end of the plan year following separation from service, or
  • One year after the end of the plan year that is the fifth plan year following separation

Since these rules are meant to speed up the date benefits begin, if benefits would begin sooner under the distribution rules applicable to all qualified plans, then those would override the ESOP rules.

ESOP Contribution Limits

For 2020, the limit on contributions to defined contribution plans, including contributions to the ESOP on the employee’s behalf, are limited to the lesser of $57,000 or 100% of compensation. For 2021, this limit will be $58,000.

ESOP Distributions

Once an employee is entitled to a distribution from the ESOP, they have the right to take benefits in the form of employer securities, with certain exceptions. The right to receive employer securities will not extend to that portion of the employee’s account which he or she elected to have reinvested under the diversification rules.

Employees who take a lump-sum distribution of their ESOP account in the form of employer stock may enable deferring further taxation of the value of that stock until they sell it at a later date.

More Information

ESOPs have tax benefits to employers and incentivize employees with ownership in the company. To find out more about ESOPs or other finance needs, reach out to us at 314-961-1600 or schedule directly here to discuss your situation.

David Smith helps businesses and individuals develop smart business practices for tax and accounting advantages as the president of Smith Patrick CPAs. He serves on MOCPA’s Legislative Policy Task Force and MOCPA’s Firm
Leadership Committee. Reach him at 314-961-1600 or schedule directly here.

About Smith Patrick CPA

Smith Patrick CPA is a St. Louis-based, family-owned CPA firm dedicated to providing personal guidance on taxes, investment advising and financial services to small businesses and financially active individuals. For over 30 years, our firm has focused on providing excellent service to businesses, non-profits, individuals and government agencies in St. Louis and the surrounding areas. Investment Advisory Services are offered through Wealth Management, LLC, a Registered Investment Advisor.