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What Is An ESOP?

What Is An ESOP?

An ESOP (Employee Stock Ownership Plan) is an employee benefit plan which makes the employees of a Company owners of stock in that Company. ESOPs are designed by law to invest primarily in employer securities and ESOPs are also unique in their ability to borrow money, also known as “leveraged ESOPs”.

How Do ESOPs Work?

A Company that wants to setup an ESOP will create a trust to which it makes annual contributions. Those contributions are allocated to the individual employee accounts within the trust. The most common method of allocation is in proportion to the employee compensation. However, other formula driven methods can be utilized. The shares of the Company stock and other plan assets allocated to employees must vest before employees are entitled to receive them. Vesting schedules can vary. For plan years beginning on or after January 1, 2007, the ESOP must comply with vesting provisions under the Pension Protection Act of 2006 (“PPA”) in that 100% vesting will occur after 3 years of service or 20% per year beginning in year 2 and continuing through year 6. An exception to this is that leveraged ESOPs with a loan in place on September 26, 2005 may continue to use the 5 year cliff vesting or 7 year graded schedule until the plan year in which the ESOP loan is fully repaid.

When an employee in an ESOP, who has at least 10 years of participation in the ESOP, reaches age 55, he or she must be given the option to diversify his or her ESOP account up to 25% of the value. This option continues until age 60, at which time the employee has a one-time option to diversify up to 50% of his or her account. For ESOPs that hold publicly-traded employer securities, the provisions of the PPA require that all participants be allowed to direct the portion of their accounts attributable to employee contributions and elective deferrals that are invested in the publicly-traded employer securities to other investment options. For the portion of employer contributions other than elective deferrals, the same diversification rights must be given to each participant with at least three years of service.

Employees will receive the vested portion of their accounts upon termination, disability, death or retirement. These distributions can be made in a lump sum or in installments over a period of years. If employees become disabled or die, they or their beneficiaries receive the vested portion of their account right away.

Distributions from the ESOP are normally made in cash, unless the participant specifically requests that the distribution be made in stock. In a publicly-traded Company, employees may sell their distributed shares through the stock market. In a privately held firm, the Company must give the employees a put option on the stock for 60 days after the distribution. If the employee chooses not to sell at that time, the Company must offer another put option for a second 60 day period starting 1 year after the distribution date. After this period, the Company has no further obligation to repurchase the shares.

An ESOP can make installment distributions, provided that it makes the payments in equal amounts and over a period, starting within one year for a retirement contribution and within 5 years for a pre-retirement contribution, not to exceed five years in either case. The Company is required to pay interest to the participant on the unpaid balance of an installment distribution.

The rules for implementing and maintaining an ESOP are complex. Plan sponsors interested in instituting an ESOP for their company would be well advised to contact qualified legal counsel and other qualified professionals as needed for this initiative.


If you need more information regarding this or any other topic affecting your retirement plan, visit our Withum ERISA Knowledge Corner online, follow us on Twitter at WSB_ERISA or contact us at ERISAhelp@www.withum.com to arrange a free consultation today.

The information contained herein is not necessarily all inclusive, does not constitute legal or any other advice, and should not be relied upon without first consulting with appropriate qualified professionals for your plan’s individual facts and circumstances.

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