Must-Knows About ESOPs

If you’re venturing into the world of employer stock, it helps to know the acronyms, because the landscape is cluttered with them. There are RSUs (restricted stock units), ISOs (incentive stock options), and NSOs (nonqualified stock options). There are also ESPPs--employee stock purchase plans. And then there are ESOPs--employee stock ownership plans.

ESOPs tend to get the least play of all of these types of programs. But there's a fair amount riding on them: There are currently more than 6,000 such plans in the United States, with 14 million participants and containing about total assets of $1.4 trillion. That's less than in 401(k) plans, which currently have about $7 trillion in assets and cover 60 million active participants, but definitely not insignificant.

In contrast with RSUs and stock options, which are typically “extras” in addition to the retirement plan, an ESOP is a tax-deferred qualified retirement plan that is subject to regulation by ERISA. The difference between an ESOP and a 401(k), however, is that the ESOP participant receives shares of employer stock rather than investing in a diversified basket of securities, as is typical in a 401(k). To further complicate matters, an ESOP may stand on its own or be set up inside the 401(k). Most companies that offer an ESOP also offer a 401(k) plan. Both public and private companies can create ESOPs, but the plans tend to be most heavily concentrated among private employers, especially smaller and midsize businesses.

While ESOPs may help align employees’ interests with the stock, plan participants often face strictures around how often they can diversify out of the stock and into other investments. Additional risks can come into play if the ESOP was created through leverage (that is, borrowing money to fund the plan) and/or the company is on shaky financial footing. Because most ESOPs are fielded by private companies, the data on ESOPs' performance is spotty. Some studies have found a correlation between ESOP participation and better retirement readiness, but the ESOP landscape is also littered with plans that turned out to be a terrible deal for their employees: Enron, Kodak, RadioShack, Polaroid, and United Airlines all had ESOPs.

ESOP Basics

ESOPs are typically set up as a way for companies to transfer ownership from the company's original owners to employees. A small percentage of ESOPs are in publicly traded companies, but most ESOPs are private. Publix Super Markets PUSH, with more than 200,000 employees, is currently the largest ESOP in the U.S.

By creating the ESOP, the owners are able to find a buyer for the business--the employees, via the ESOP; the owner can also retain control of the business. In addition, the owners receive tax benefits for their contributions of stock to the employees’ accounts and defer the capital gains taxes that would normally be due upon the sale of a business.

In addition to serving as an exit strategy for the company’s original owners, ESOPs are touted as a way to incentivize employees and align their activities with the broader business. ESOP participation can also be used as a retention tool: Like other forms of employee stock ownership, such as RSUs and options, ESOPs are usually subject to vesting schedules before the employee actually owns the stock, as well as strictures around when the employee can diversify into other holdings.

There are two main types of ESOPs: non-leveraged and leveraged. With a non-leveraged ESOP, the business owner contributes stock or cash to the plan (technically a trust); the stock is then distributed to employees via the ESOP. With a leveraged ESOP, the financing is a bit more complicated. In that instance, the company borrows money from a bank to purchase the stock (at a price established by a third party), then repays the loan through contributions of stock to employee accounts.

Tax Treatment for Employees

An ESOP is a tax-deferred retirement plan, so that means that the tax treatment works much like other traditional tax-deferred retirement plans like 401(k)s. ESOP contributions aren’t taxable to employees as long as the money stays in the plan, and withdrawals in retirement are usually taxed at the participant’s ordinary income tax rate. As with a 401(k), employees don’t have ready access to the funds in the plan. If the employee leaves the employer or retires, the employee can then roll over the funds to an IRA or take out the money. If it's the former--the funds are rolled over--the fund retains its tax-deferred status. If the employee cashes out, she’ll owe ordinary income tax on the withdrawal, plus an additional 10% penalty if she’s not yet 59.5 years old. If an employee wants to take a distribution from the ESOP in retirement, he or she can either take a lump sum or the distribution as a series of substantially equal payments over a period of up to five years.

If the employee takes a distribution from the ESOP in the form of company stock rather than cash, doesn’t roll the money into an IRA, and has another qualifying event (retirement or disability), he or she is also eligible for special tax treatment called net unrealized appreciation. In that instance, only the cost basis on the company stock is taxed as ordinary income; appreciation above the cost basis is eligible for the long-term capital gains rate.

ESOP Strategies

As with any form of employer stock, employees who own shares in their companies via an ESOP court the risk of being overexposed to their firm’s fortunes. Thus, it’s a best practice to unload company stock as soon as is practical and shift the funds into a more broadly diversified investment, like a sturdy target-date fund.

A countervailing force, however, is that the employee may be constrained in terms of whether and how she can diversify--the employee must have attained a certain age or years of participation in the plan. For ESOPs in private companies, the Internal Revenue Code states that companies must allow ESOP participants to diversify if they have reached age 55 and have participated in the plan for at least 10 years, but plans may have more liberal standards for diversification than that. If the company is public and the ESOP is part of a 401(k) plan, participants are allowed to diversify out of the stock after three years’ worth of service.

In addition to the limitations on diversification, some ESOP participants may have even more reason to worry. That's because roughly half of ESOPs are leveraged, meaning the ESOP was created with borrowed money. In that instance, the company is simultaneously making contributions to the ESOP, servicing the debt load, and also attempting to run its business and grow. If employees depart and need to get their money out of the ESOP, the company will have to find the funds to pay off those departing employees who are cashing in their shares. If employees are leaving because of layoffs, that can create a "death spiral" for the company because it's juggling so many priorities. Management may not be able to reinvest to maintain the business, which could result in further layoffs. Those actions, in turn, can drive down the share price. A related risk factor is that ESOP participants in private companies don't have a ready market for the shares they'd like to unload; there are risks that the employee may not receive cash payments in a timely fashion or even a fair valuation for their shares.

That underscores the importance of knowing whether your ESOP is leveraged, and also staying apprised of your company’s financial health. If your employer offers an ESOP, do your homework by answering the following questions.

• Is the ESOP leveraged?
• How are shares valued, and how often?
• What are the rules regarding vesting?
• What are the rules regarding diversifying out of the stock?

And if an ESOP is part of your compensation and retirement plan, it’s wise to seek out advice from a financial advisor who’s well-versed in them, to help you manage the risks, taxes, and best course of action from an investment standpoint.