Holly founded ExitPromise.com as well as StartupPromise.com and so far has answered more than 3,000 questions asked by business owners about starting, growing and selling a business.
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The method chosen to transfer ownership of a business for sale is one of the most important factors to consider as a business owner. And the reason for its importance is related to the wide differences in the amount of cash received (net of taxes) by the business owner across the various methods of transfer or sale.
An ESOP or Employee Stock Ownership Plan is one method of ownership transfer or sale business owners consider when they decide it’s time to retire. That said, let’s explore the ESOP as a potential method of transfer or sale from both the business owner’s and employees’ perspectives.
How Does an ESOP Work?
When a company wants to set up an ESOP, it establishes a trust fund. The company then contributes new shares of stock or cash to buy existing shares. The shares are divided among employee accounts within the trust. Vesting schedules vary between individual plans, but employees must receive vested benefits on either a cliff vesting schedule, which is 100% vested after 3 years or less, or on a graded vesting schedule, which provides 20% vesting every year after the second year of employment.
Employers pay ESOP distributions when employees leave the company. The employee is given the stock they have accrued, and the company must buy back the shares at a fair market value if there is no public market for them.
How Does an ESOP Get Funded?
There are three main ways ESOPs get funded.
1. The business can put new shares directly into the ESOP trust fund.
2. The business can put cash into the fund to buy existing shares.
3. The ESOP can be used to borrow money to buy the business’ stock shares.
All company contributions to the fund are tax-deductible.
Is an ESOP a Qualified Retirement Plan?
ESOPs are qualified retirement plans, meaning they satisfy requirements laid out in Internal Revenue Code Section 401(a).
Despite this, employees should not depend on an ESOP as the sole method of financing their retirement.
For instance, if the company stock fails to increase in value or decreases, the employee’s benefit remains flat or loses value.
If the company closes completely, the employee will lose their benefits entirely.
And while varied investment options exist after an employee has participated in the ESOP for 10 years and has reached 55 years of age, ESOPs can lack essential diversification.
The ESOP vs 401K Plan
Both ESOPs and 401(k) plans are retirement accounts offered by employers.
With a 401(k), the employer’s contributions are tax-deferred, meaning that the money is taken out of each paycheck before taxes, and those wages are not taxed until withdrawal.
Whereas with an ESOP, employees also do not pay taxes on the shares in their account until distribution.
In both situations, employers may offer matching contributions.
How is an ESOP Beneficial to a Business Owner?
ESOPs are beneficial to business owners in several ways.
1. The owner can sell part or all of their shares to their employees, while still retaining control of the business operations.
2. Establishing the ESOP trust also ensures there is a market for the owner’s shares.
3. Transfers to an ESOP allow the business owner to defer or bypass capital gains taxes.
4. ESOPs come with even more tax benefits:
a. contributions of stock and cash are both tax-deductible.
b. when the ESOP is used to borrow money, both the loan repayments and interest are also tax-deductible.
5. Allowing employees to own part of the company can also result in increased loyalty and productivity, as they have the ability to impact the value of the stock directly.
How an ESOP may be Beneficial to Employees
If the company has done well, an ESOP account may have performed better than typical investments in an index fund.
Contributions to the ESOP are also permitted to grow tax-free until the distributions are paid. When employees receive their ESOP distributions, they have the option to roll them over into an IRA or other retirement plan and avoid paying taxes until the money is withdrawn for retirement.
I understand that I can take my money out of the company ESOP plan when I retire. Is there a minimum retirement age for these plans?
Hi Roy,
The minimum retirement age for your ESOP will be defined in the Summary Plan Document. You should have a copy of this document. If not, ask your Human Resources department for it.
All the best…
My husband recently passed away and had an ESOP with a former employer. As his beneficiary, how much am I entitled to?
I have esop with my company,in June is the time to get the money.in June 28 I’l Be 70 years and could I get all amounts of money?
Hi Gordana,
Your ESOP plan is a form of retirement plan which means at your age 70 and one half, you will be required to begin taking distributions from the plan — even if you are still working for the company.
The ESOP Plan, which is a written document you should have access to or have a copy of, will describe when you may withdraw money. You should read this document carefully and discuss your options with your human resource department and/or your accountant/CPA.
It’s important to understand that when you do take distributions or if you choose to take all of the money out of the ESOP, it will be taxable income to you. If you don’t take all of the money out at one time, you may be able to roll over the balance to an IRA.
I encourage you to ask questions and seek guidance from an advisor in your area before you take a distribution from your ESOP Plan Gordana.
All the best…
Hi Cathy,
I am very sorry for you loss.
An ESOP is similar to other forms of qualified benefit programs in that the employee has the ability to designate a beneficiary in case of his/her death.
You should contact the administrator of the ESOP and provide them with your husband’s death certificate. If you are identified as the beneficiary in your husband’s account/plan, you will be entitled to the benefits.
My condolences to you and your family…
Hi, i worked for a company for 8 years was fully vested in esop. The company closed and we were told we could get our money after the company had been closed 6 years, it will be 6 years march 2018, now THM is saying we can’t have it unless we are 55 or worked over 10 years there. Our policy book and Human Resources say we can have it at the 6 year close date. What can i do? Thank you
Hi Jerry,
I am sorry you are having difficulties.
If you were fully vested, I’d find it very difficult to believe you couldn’t access your ESOP.
You may not be aware that it’s possible to find out much about your company’s ESOP, which is under ERISA regulations.
Here’s a website which may be helpful to you. It allows you to access details about your company’s ESOP/Retirement plan and 5500 annual report. Hope this proves to be helpful to you.
All the best…
Holly, My husband has told me that I need to sign a form so he can roll his esop over to an IRA. What do I need to consider before signing? I know that he will not name me as his beneficiary on the IRA. Thank you!
My employer is switching from a “profit sharing” system to ESOP. As of this year I am completely “vested” thru my profit sharing account. Is it wise to roll my profit sharing into the ESOP or a 401K? I do not know much about either.
Hi Andrea,
The main difference between investing in an ESOP vs. a 401K is diversification.
When you’re fully invested in your company’s ESOP, you’ve got an investment concentration because you only one one stock — the company you work for.
Whereas if you invest in a 401K, you should have many options to invest in many companies or mutual funds.
Generally speaking, ESOP participants have the ability to invest in the company’s stock as well as outside investments. It doesn’t have to be an all or nothing decision.
So ask your ESOP advisors more questions and carefully consider both options.
All the best…
My company is merging with another company. I have an ESOP program with my current company.
Will the new company buy me out??
If so, what should I do with that money so I don’t get penalized or taxed?
How should I invest that money??
Hi Joe,
One of the benefits of being an employee in an ESOP is being able to participate in the growing value of the business which employs you.
The merger may allow for employees to receive cash. It also may not. So, you should raise your hand and just ask.
If you do receive cash from the transaction, you would not be penalized. You may owe taxes on the transaction and should put away some of the money to cover that next year when you file your federal tax returns.
I am sorry I am not able to advise you as to how to invest your money. You should consult with a financial advisor who is familiar with your personal financial circumstances.
Wishing you and the other ESOP members well!
Hi, how much percentage would be taking out of your Esop if you were to cash it in?
Hi Jenn,
Well, that depends. If your taking cash out of your ESOP, it will be subject to your ordinary federal tax rate. If you are under the age of 59 1/2 years of age, not disabled, or not terminated after the age of 55, another 10% penalty tax will be owed too.
The actual amount your ESOP actually withholds when the distribution is made to you may vary. The final tax on the distribution will be owed when you file your federal tax return for the year in which you receive the distribution.
Can you give an example as to what an employee can expect as a return if they contribute $500 a year for 10 shares each year for 30 years and the company grows at whatever the average rate is? I’m trying to figure out how much we’re looking at here and if it’s right for us.
Hi Liz,
There is no such thing as an ‘average rate’ of company growth in the private market where ESOPs are used. So I am not able to help you with your request, I am sorry.
So would it be correct to say that in order for an employee to rollover an ESOP account, to another type of retirement account/investment, , they would need to take a distribution first? Which I believe does involve capital gains taxes on the distribution?
Good morning Sheila,
Just like any other type of qualified retirement account, a participant in an ESOP may chose to rollover the ESOP account into an IRA in one of two ways to defer federal taxation until it’s ultimately paid to the beneficiary. The first way is a “direct rollover” from the ESOP to the IRA Custodian. The second way is by taking the distribution from the ESOP and then contributing it to an IRA within 60 days. It’s generally best to initiate a direct rollover.
All the best Sheila…
Holly
So would there be any taxes due at the time you do a distribution?,( as opposed to a roll-over into an IRA.) What else constitutes a “like” transfer/rollover besides an IRA?
Good morning Sheila,
If you chose to handle the transfer as a ‘direct rollover’, then no federal tax needs to be or will be withheld by the ESOP.
If you chose to take the distribution and then contribute it to an IRA within the 60-day period, typically the distributing custodian will ask the participant to complete a form W-4P which asks you to tell them how much federal tax is to be withheld from the distribution. If you are contributing the distribution to a qualified IRA within the 60-day window, then you do not have to withhold federal income tax because the rollover would be tax free. This is tricky because if you take the distribution and roll it over (and not chose to do a direct rollover), you will receive a 1099 form showing income at the end of the year. It will be your burden to prove to the IRS that you rolled over the distribution within the 60-day window. That’s why it’s really much easier and better to elect a direct rollover from the distributing custodian to the receiving custodian.
Another type of transfer available to you would be a ROTH IRA, however the full amount would be taxable to you at the time of distribution. You should consult with your CPA about your specific tax consequences before considering this option.
All the best Sheila..
Why would a company stop giving shares
Hi Antonio,
I don’t have enough information to answer your question Antonio. If you could fill in the blanks a bit, I would be pleased to offer you my thoughts.
All the best…