Popular Types of ESOPs: Leveraged vs. Non-Leveraged

There are several types of ESOPs, but one of the most popular is a leveraged ESOP. In a “leveraged” ESOP, the ESOP borrows money and buys the owner’s stock. The Company usually guarantees the loan, and contributes enough money each year to enable the ESOP to repay the loan.

In a “non-leveraged” ESOP, the ESOP uses company contributions to purchase stock each year from individual owners or from the company. The company deducts the contributions from its taxable income. The ESOP stock is allocated to employee trust accounts and when employees retire, they receive their shares or the cash value of those shares. Since ESOPs are extremely flexible, there are many variations on this arrangement.

Examples of How ESOPs WorkiStock_000004737163XSmall-informal-meeting

Complete Buyout of a C Corporation Shareholder, Followed by a Corporate S Election

Basic Stock Bonus ESOP

Leveraged ESOP Financing

ESOP Basics

Employee Accounts

  • Stock is valued annually by an independent valuation firm
  • Contributions & allocations are made to employee accounts, usually based on pay for people who work over 1000 hours/year
  • Participation – plan can have age and service eligibility rules
  • Vesting – can be immediate, often 6 year graduated or 3 year cliff
  • Distribution upon death, disability or retirement, or termination for other reasons if vested
  • Taxes –taxed as pension with rights to rollover to IRA
  • Growing your ESOP balance is based on increased value in the company, years of employment, and generally rate of pay

Contributions to the ESOP

  • Employees do not contribute to the ESOP
  • Board of directors determines contribution amount each year – discretionary, but must be regular
  • Except – if money borrowed through ESOP, allocations must be made to employees as loan is repaid
  • Allocated to account as of end of plan year
  • Employee portion typically based on your eligible compensation – can be flatter
  • Stock must be valued annually by an independent appraiser

Vesting for Employee ESOP Accounts Below are legal limits, but the plan can be more generous:

  • Year of service = 1,000 hours
  • Prior service may count
  • Graduated vesting schedule beginning at year 3 and ending in year 7 or 100% vesting after 5 years
  • Exceptions - Retirement, death, or disability
  • Forfeit unvested balance

Distribution Start Timing

  • Retirement, death, or disability- No later than one year after end of final plan year
  • Any other reason - No later than five years after end of participant’s final plan year, unless there is an outstanding acquisition loan

Distribution MethodMorgue-DSC04776-construction-web

  • Most distributions are in cash
  • In some plans, employees can demand stock
  • Right to demand cash if company is not publicly traded
  • Single lump sum or Annual installments
  • Over no more than 5 years

Taxes on ESOP Distributions You can defer taxes by rolling over your ESOP distribution to an:

  • IRA
  • Other qualified retirement plan
  • If you take the cash before age 59 ½, there is:
    • 20% federal withholding
    • 10% early withdrawal penalty
  • If you take a stock distributions:
    • You are not taxed on the net unrealized appreciation while the stock was in the ESOP
    • A privately held company must let you sell your stock back to company – Put Option

How Employee ESOP Balance Can Grow

  • Shares added to employee account because:
    • Shares of company stock contributed as required by a leveraged ESOP loan
    • Shares contributed in exchange for ESOP purchase from an owner
    • Additional shares contributed by company as a stock bonus or profit sharing
    • Shares forfeited by partially or non-vested participants who leave employment
    • Shares redeemed from retirees and then re-contributed to ESOP by the company

Change of share value in employee account

  • Shares can increase in value with greater employee participation and continued product/ service innovation based on long-term stake
  • Value can decrease due to market pressures, poor management, or catastrophe– but participatory employee ownership can turn these around