As you progress in your career, especially if you work in corporate America, one of the first changes you see is in your compensation. Instead of simply getting an increase in pay, corporations often incentivize their employees, and attract new hires, by offering equity - or the opportunity to buy equity - in the corporation.
To that end, we're kicking off a series walking you through the different types of equity-based compensation and employee benefits.
If you're needing to read these articles to figure out what's being offered to you, then congratulations, because being offered equity-based pay means you're likely on that right track professionally! Hopefully these posts provide some clarity and allow you to form an action plan.
In Part 1, we covered Restricted Stock Units, or RSUs for short.
In Part 2, we covered Stock Options, both Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs).
In Part 3, we covered Employee Stock Purchase Plans.
Today in Part 4, we're covering Employee Stock Ownership Plans!
In discussing equity-based pay, we're breaking each form of compensation into one of two types:
- Will Be Yours: equity in the company that you WILL have if you meet certain conditions
- Could Be Yours: equity in the company that could be yours if you meet certain conditions AND have the money to pay for it
The Restricted Stock Units we covered in Part 1 are Will Be Yours benefits; if you meet the terms required for them to vest, you will get your shares of stock.
The Stock Options covered in Part 2 are a Could Be Yours benefit. A company gives you the option to buy a certain number of shares at a predetermined price, and those shares could be yours IF you have the money to pay for them within a set period.
In Part 3 we covered Employee Stock Purchase Plans, another could be yours benefit. Companies offer their employees the right to buy common stock at a discount to its fair market value, but the employees only owned the stock if they decide to purchase.
Today's subject, Employee Stock Ownership Plans (ESOPs), allow company owners to grant employees the opportunity to buy into ownership. ESOPs can operate as either a Could Be Yours benefit, where the employee must contribute their own funds to buy into ownership, or Will Be Yours benefit, where the only requirement is that the employee stay long enough to meet certain vesting requirements.
While there are several tax benefits and reasons a current owner would do an ESOP, since this series is based on equity compensation, this post will focus primarily on the impact and treatment of the ESOP to the employee.
How Do ESOPs Work?
There are a few steps involved in setting up an ESOP:
The first step in administering an ESOP is to establish and fund a separate trust to hold the shares of company stock that will eventually be given to employees.
Enough money will be placed into the trust to equal the company's value in stock as determined by an independent appraiser, or enough for a down payment on the company's value to be paid to the owner.
In a non-leveraged ESOP, the company will put the money in the trust needed to compensate the owner.
In a leveraged ESOP, the company will secure a loan for the necessary amount.
The newly established trust will now pay the owner for their company stock and transfer the stock into the trust.
The owner does not have to transfer all the company stock, nor do they have to stop working there. In fact, most ESOPs are established by owners who want a small portion of the company's value now but prefer to stay involved for another 5-10 years while their employees buy them out. In fact, the owner isn't even required to sell the whole company or even a majority interest, as some will sell a minority interest through an ESOP arrangement and sell the rest in a later transaction.
For these, it's rare that the trust would pay the owner the company's full value immediately. They're more likely to receive a portion of the company's value, say 40%, along with a promissory note from the company to pay the rest over an agreed-upon period.
Once the trust holds the shares of company stock, it can start to distribute them to employees' retirement accounts according to the vesting schedule of the ESOP.
Unlike a 401(k), enrollment in an ESOP is automatic once you meet the minimum tenure to participate.
ESOP shares are typically allocated based on the salary and tenure of employees, and there is often no cost to the shares. The more you make and the longer you work for the company, the more shares will be allocated to your account.
By "your account", I mean whatever structure the company has established to allocate employees' stock. An ESOP is an ERISA-covered retirement plan, similar to a 401(k). There are companies that keep their 401(k) and their ESOP plans separated, placing employees' stock directly in their ESOP plan, and there are those who establish 'KSOP' plans, which contain both 401(k) and ESOP features.
The fourth step is when employees turned owners cash out or transfer their company stock as a distribution.
As for how you can take these distributions, it's time we introduce a topic we've yet to cover during our series: Net Unrealized Appreciation.
What Is NUA?
When an employee-turned-owner leaves a company under qualified circumstances, such as being over the age of 59 1/2, they're eligible for a distribution of their shares in the ESOP.
The way they take this distribution will determine the tax consequences.
Option 1 is to sell the shares back to the ESOP for cash and take the money as a lump sum. If they do, the entire transaction is taxable as ordinary income.
Option 2 is to take advantage of the ESOP's status as a qualified retirement plan and roll the shares over into an Individual Retirement Account. Inside of the IRA, they can keep the investment in company stock or sell the shares and diversify into other investments.
Taking advantage of this option would mean continuing to defer taxation. When the funds are withdrawn, however, you would pay income taxes on the amount withdrawn.
Option 3 is to take advantage of Net Unrealized Appreciation.
Net Unrealized Appreciation occurs when an employee takes a distribution of company stock that has appreciated in value, but not been taxed.
When a stock distribution meets the rules that make it allowable as an NUA distribution, the tax benefits can be substantial.
First, the cost basis of the stock (the cost of stock at the time it was purchased or granted) is immediately taxable as ordinary income. With an ESOP, where the shares of company stock are typically not paid for by the employee, this means paying taxes on whatever the value of the shares were at the time they were placed in your account.
Any growth between the cost basis and the value of the shares at the time of the distribution (remember that as of this point, the employee still holds the shares) will be taxed as a long-term capital gain when the shares are sold. If there has been any further growth in the stock value by the time of the sale, the additional growth is taxed at either short-term or long-term gains, depending on the holding period.
Assume you have an employee/owner who had $100,000 of company stock contributed to their ESOP. At the time they take the distribution, the stock has grown to $200,000 in value. They then wait 6 months and sell the shares when they are $300,000 in value.
To recap: the first $100,000, the cost basis, is immediately taxable to the employee as ordinary income. The balance between $100,001 and $200,000 is the Net Unrealized Appreciation. In other words, the amount the stock has grown in the time between its contribution to their account, and when they took the stock out as a distribution. This NUA is taxed at long-term capital gains rate of either 15% or 20%.
The taxation of the final tranche, the difference between the $200,000 value at distribution and $300,000 value at sale, depends on the holding period. Since our employee/owner held it 6 months, the gain would be a short-term capital gain, taxed at ordinary income rates. Had they waited at least a year and a day, it would have qualified for the long-term gains rate of 15% or 20%
The ability to pay capital gains taxes on the NUA is a potentially large benefit if the value of your company stock has improved significantly. But you have to make sure you meet a number of requirements in order to qualify.
- The entire account must be distributed in a single tax year: while this requirement doesn't mean you have to liquidate your ESOP in one transaction, it does mean the account must Have a zero balance by the end of the tax year in which the initial distribution was made.
- Company stock must be transferred 'in-kind': this requirement means you transfer the company stock as is to a particular type of new account (see below). You cannot sell the company stock for cash and then repurchase company stock in your new account.
- The stock cannot be rolled into an Individual Retirement Account or 401(k): you are not required to seek NUA treatment on all company stock. If you prefer to delay the taxation, you can roll all or a portion of your company stock into an IRA or 401(k), as detailed in option 2 above. But for any portion of company stock where you are seeking to take advantage of NUA, these shares cannot be transferred into an IRA. They must be transferred into a nonqualified (i.e., nonretirement) brokerage account.
- The distribution must be made after a triggering event: remember that an ESOP is an ERISA-covered retirement plan, meaning the triggering events are similar to what you find in a 401(k). In order to qualify as a triggering event, the owner must be over age 59 1/2, have died, experienced the disability, or separated from service
And now, let's finish things up with some FAQs about ESOPs:
What Happens If I Leave My Job Before Age 59 1/2?
If you quit your job or are fired, you must wait six years before receiving distributions from your ESOP. Following this waiting period, the balance of your account is paid out in installments over a five-year period.
How Long Does It Typically Take To Vest In An ESOP?
ESOPs typically carry a 3 to 4 year vesting requirement.
Can You Sell ESOP Stock On The Open Market?
All ESOP agreements have a document outlining the rules and regulations of the plan, including how shares can be transferred or sold. If the company is a private company, then obviously you would not be able to sell shares on the open market. Your options in this case would typically be to sell the stock back to the plan in exchange for cash. If you're still an employee at the time you desire to sell the shares, the plan will likely restrict or disallow these transactions until you've separated from service. Even after you separated, there may be a waiting period required or a restriction that states shares may only be sold back to the plan or to another shareholder.
For public companies operating ESOPs, these shares may still be considered restricted in terms of who can purchase them
Do all ESOPs give their employees shares for free?
No. There are ESOPs who treat the shares offered to vested employees like stock options, or the employee has to pay to acquire the percentage of ownership.
Is There A Penalty For Accessing My ESOP Early?
Yes. Similar to a 401(k), the penalty for accessing an ESOP before you've had a triggering event is a 10% penalty, in addition to ordinary income taxes on the amount distributed.
Here's the bad news about ESOPs. As a person who spends all of their professional days looking at financial documents, understand that even for me, ESOPs are a complex subject to tackle. The tax rules all carry multiple steps that if not done correctly, can nullify benefits or lead to penalties. The agreements themselves vary from company to company and necessitate your reading them with a careful eye. And it's rare to find an owner that is both willing to receive the value of their company over a period of time rather than upfront, and also willing to share in the ownership of that company with their employees.
But here's the positive news: if you have found that owner willing to offer an ESOP, and one that thinks enough of you to allow you to participate, you are now in position to co-own a company without having to apply for a business loan or risk the stability of your paycheck. And in many cases, without having to contribute any money at all! So, cherish the opportunity enough to fully research how the plan works and how it can be used to your benefit.
We hope you've enjoyed this series thus far, and in Pt 5, we're covering another form of equity compensation: Restricted Stock Awards, or RSAs. See you then!