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.
Hello,
My company ESOP is being closed out (Company being bought out and we have to take a distribution ) I have to detemine what to do with the money. I will probably roll the money over into the already estblished 401K, for several reason but mostly because in about 4-5 months my husbad and I will both be 59 1/2 and can acess the money and invest how we choose or leave it, bottom line we just need time to think. The main question since we have not been left with a lot of time to make very many informed choices. How much can we rollover into the 401K? the ESOP has a decent balance. >400,000
Hi Troy,
As long as the ESOP and the 401K plan allows for rollovers from the ESOP to the 401K plan, all of the ESOP may be rolled over.
You should consult with your ESOP advisor as they will have the documentation to verified this is permissible.
All the best…
How can I collect my ESOP share, I’ll be 80 years old on October 28,2023. I wrote the person in -charge of the ESOP but I did not receive a response. I have read that an employee filed a case against the company. Can I join the complainant? Thank you
I left my company and am only 51. I had 8 years in the company and have an esop and a 401 k. I have to move the money out of the esop in two weeks . Can I move the esop to the 401 k. Without penalty and any money taken as cash has a 10 % penalty?
Hi Patrick,
Yes, your vested shares (which will be distributed to you in cash) may be rolled over to a 401K. It also may be rolled over to an IRA without tax or penalty for early withdrawal.
It’s always best to a rollover ‘direct’ from one plan to another so it’s reported to the IRS as a rollover.
Consult with your ESOP advisor!
All the best…
I work at a company that is currently in the process of being acquired by another company. We have an ESOP retirement plan and I was wondering what my options are. The current company I work for keeps telling us to wait until the company is completely sold because then our assets would double, but the company acquiring us does not have stock. I have also heard of other companies being bought out and employees losing all of their benefits after being told this as well. Do I need to do something before the company is acquired so I don’t lose any of my benefits? I want to be smart about this and make the right decisions.
Thank you in advance for your help!
Amber
Hi Amber,
After the sale of the business you work for, the acquiring company which does not have an ESOP will pay you for your vested shares and any cash in your ESOP 401K. This happens after all of the business’ liabilities are paid.
So it is possible, ESOP participants may not receive anything or much after the sale.
Of course, all of this depends on the circumstance — and I have no idea what they may be.
As an ESOP employee you have the right to receive an annual statement from your employer showing the value of your ESOP shares and any cash balance.
I’d start with this information in hand and ask your HR department and ESOP representatives what they estimate you will receive post-acquisition from the buyer.
Hope this helps a bit…
Hi Holly, I worked for a company for about 2 years and I have a 401k at about $16k and an ESOP with a balance of 9,412.30 as of 12/31/2019 and a vested balance of $3,764.93 as of 12/31/2019. I don’t understand what the 2 ESOP balances are, and what I should do with them. Since I no longer work for them will it continue to grow or will it just sit there. Does it make sense for me to withdraw it? Also, is the $3764 part of the $9412 or in addition to?
Thanks for any info you can provide…
Hi Mary,
The ESOP vested balance is most likely part of the total balance. This is because when money is contributed by your employer into an ESOP, the money doesn’t belong to you (vest) until your employment reaches a certain amount of time. The specifics are defined in your ESOP plan document and even though you are no longer employed by the company, you should be able to request a copy.
If the company continues to do well financially, the value of your vested share of the ESOP should grow.
An ESOP is a qualifed retirement plan, so the rules associated with withdrawing funds and paying income taxes would apply.
I’d start investigating your options by requesting a copy of your ESOP plan document.
All the best…
I left my company almost a year ago and received an ESOP contribution in Jan 2020…the company put my account in a 401k..which 14k is not vested..I was told by Transamerica that I forfeited that money because I quit the company before I was fully vested..I was with the company for 3 years and received 2 esop contributions from this company…I had no idea I would even receive the 17K they put in my 401k account. This year…now I was told I would lose the money…the company discontinued the ESOP plan..and it’s now in their 401k plan…Since this was an ESOPcontribution..will I still forfeit the remaining 14k..confused!!!
Hi Beverly,
Both 401K plans and ESOPs are Retirement Plans. And both can have requirements that prevent employees from having full or 100% vesting rights until the employee has worked for the company for a specific amount of time.
It sounds to me that this may have been your situation.
The only way to know if the contribution the employer made into the 401K Retirement Plan is to contact the Retirement Plan’s Administrator.
Any amount of compensation you may have put into the 401K from your paycheck in the form of a withholding will be 100% vested.
Hope this helps a bit…
If your 100% vested amount is $100,000 in an ESOP, do you receive this entire amount of money when you retire or do you just get smaller amounts according to company shares? I already had first two payments sent to me, the first being a good amount but the next being a much, much smaller amount. Are we just receiving 25% of the shares and not the entire cash value of $100,000?
Hi Holly,
Are all ESOPs required to allow employees to diversify their shares after reaching age 55 and participating in the plan for 10 years? My company’s ESOP has a graduated vesting period. 100% after 6 years. Does the 10 years participation include the first year waiting period?
The owner of the company is in his 70’s and likely to retire soon. There is no clear cut plan of succession and I’d feel better if I could move funds from company stock to my 401k.
Thank you.
If a long term employee is at retirement age at the time the company becomes an ESOP can they be forced to wait until the vesting period (3-5 years) is reached before having access to the retirement benefits ??
Hi Holly, I work for a company who has a 401k and an ESOP. When the owners presented the ESOP plan to all the employees it was very exciting. We had a big dinner and the owners said that they were going to make all the employees owners of the company. Now, we have been in the ESOP for 11 years now and all the employees hate the plan completely. The owners had been putting 15% of our income into a 401k all the years before the ESOP plan. When they started the ESOP plan they had quit putting money into the 401k plan and started giving us shares for the ESOP. When the ESOP was presented to us the plan would not start paying us out until 3 years after we left the company. Plus an additional year to wait for the evaluation of the company assets. After being excited about the ESOP for years, the company decided to increase the wait time to be paid out to 5 years plus the additional year for evaluation. That’s 6 years before we even see the first of three payment our money. Is that legal to do? The employees here are upset and the moral is way down. The employees wishes for the 401k to come back. At least if we leave the company we get to do what we want to do with the money immediately.
Hi Peter,
I am sorry you and your co-workers are experiencing difficulties with your employer’s ESOP!
Truly, ESOPs can be very good for both the business owners and the employees too. Hopefully you will have a good outcome.
Unfortunately, the ESOP distribution rules are very complicated and depend on many factors. Factors such as the employee’s age, how long they’ve been in the ESOP plan, why they left employment, etc. So, there is not a simple answer to your questions.
Generally speaking, it seems that a six-year waiting period to receive ESOP distributions is not typical.
Often, the ESOPs have a vesting schedule which means an employee doesn’t have immediate full credit for its share of equity contributed to the ESOP and has to wait for the equity to ‘vest’. The vesting time frame ranges from three to six years, depending on how the ESOP was established.
So it’s possible what’s been described to you was the vesting schedule and not the distribution schedule?
If your company has an HR department, you may want to consider asking for the plan to be described to you in plain English and on one single page. This may clarify things for you.
If they are not willing to do that for you and the other employees, I suggest consulting with an Attorney or a CPA who is well-versed in ESOPs so you can get help with interpreting the plan and learning if the plan is truly compliant with the ESOP rules that are meant to protect employees like you and your coworkers.
Hope this helps a bit…
All the best Peter.