ESOP Education Series
When do I get PAID?
An employee stock ownership plan, commonly known as an ESOP, is a type of qualified benefits plan that places employer stock in an account on behalf of the employee. Providing corporate stock to employees gives each employee a personal interest in seeing the company succeed since the stock makes an employee an owner who can benefit from corporate financial success. Employees may cash out from an ESOP plan based on the terms listed in the ESOP plan guidelines. Investopedia states that ESOPs are one strategy some companies use to align employee goals with shareholder goals by offering them an ownership interest in the company.
Imagine that you’re trying to sell your car. One person offers you $2,000, and another offers $2,000 but says he won’t be able to pay until six months from now and then will have to do it in installments. Which offer would you choose? We probably can all agree on the answer here.
Most employee-owners who have shares would probably answer similarly if given the choice to trade their shares for cash. “Why can’t I get paid now?” Almost all employee ownership plans, however, are set up to pay employees later. It’s important to understand why this is the case.
If It Really Were “Now,” It Wouldn't Be Ownership
Think about a bonus system. It's a one-time payment that adds to your wages in some manner of speaking.
Shares in employee ownership plans are different. For one thing, their value can be much, much higher. If employees could sell their shares at any time, many would cash them in as soon as their accounts grew to a healthy value. If all employees sold right away, then employee ownership would disappear, and the ESOP would be no different from a general bonus.
If employees could cash in stock whenever they wanted, then companies would have to pay out significant amounts of cash in a short time period. If a company uses its ownership plan to buy out a major owner or to acquire new equipment or maybe another company, then it has already taken on a major cash obligation. So having also to repurchase shares from employees in such a short time could be burdensome, and this could even dissuade companies from setting up plans in the first place.
What are the Rules for ESOP Distributions?
According to the National Center of Employee Ownership, an employee can receive distributions from the ESOP after employment terminates. Distributions are normally paid out as either a lump sum or annual distributions that span up to five years. Distributions resulting from reaching the plan retirement age, death or disability will start the next year. Distributions resulting from employment termination must begin within six years following job termination. Vesting determines how much the employee is eligible to receive. For example, if a fully vested employee reaches 65 and retires in 2022, their distributions will begin in 2023 and must be fully paid no later than 2028.
Are ESOP Distributions Taxable?
Distributions from an ESOP is taxable as income. However, an ESOP can also be rolled over into either a Roth or traditional IRA. If the ESOP is rolled over into a traditional IRA, it will be taxed upon distribution. If it is rolled into a Roth IRA, it will be taxed immediately. Dividend payments associated with an ESOP are also taxable, but are not taxed at the same rate as income.
Are There Penalties for ESOP Distributions?
An additional 10 percent penalty is assessed on distributions to individuals who have not yet reached the age of 59 1/2. There is no penalty if the ESOP is rolled over into an IRA, qualified retirement plan or successor plan within 60 days after receiving a distribution. The IRS also provides certain exceptions when it comes to the penalty. Inc. states that dividends received from an ESOP are not subject to penalties regardless of when payment is received. For example, if a 50-year-old employee leaves the company, they will have to take the distribution within six years with the associated penalty, or roll the ESOP over into a retirement account.
Why Can’t I Borrow Against the ESOP?
An employee-owner might ask to borrow against the amount in his or her ESOP account. This seems like an attractive option, but in practice it’s impossible for a company to provide. If the ESOP has borrowed money to buy shares initially, it cannot legally allow anyone to borrow against those shares, because they are collateral for the loan. That means that the lender to the ESOP already has a claim on those shares if the company cannot repay the ESOP loan. The lender is not going to let an employee use those same shares as collateral for a loan he or she takes out too.
Even if the shares are fully paid for (i.e., when there is no ESOP loan anymore) this is still not a safe option for the company. Since shares can go up and down in value, they are not good collateral for an employee loan.
Say Mary has a $50,000 share account balance and takes out a loan for $25,000. But then she cannot (or does not) repay the loan. In theory, she could have the ESOP sell the shares and use the money to repay her loan. In practice, this can raise some tricky legal issues. But what if the share value drops to $20,000? Then the ESOP is out $5,000, and so are you as owners. Most ESOP companies also have 401(k) plans, however, and many of these plans allow participants to take out loans against them.
It’s One Pocket or Another
It’s understandable why employees might want their money sooner than later. But the money the company saves now by delaying the repurchase of shares is money the company can use to grow, meaning the value of everyone’s shares will go up. That’s the great virtue of employee ownership. If you were not owners and the company delayed a payment to you for some benefit, the benefit of that would all go to the company’s owners. But in an ESOP, you are the owners, so it is just a matter of which pocket fills up soonest and how much.