The Risks and Rewards of ESOPs

(The second of three feature articles about ESOP Plans. We are available to answer all inquirees - just click below )

by David Binns, Beyster InstituteNote: Mr. Binns, a former Executive Director of the ESOP Association, is one of the leading experts on ESOP Plans.

What's In It For You?

So what does this all mean for a participant of an ESOP? As noted in my previous article, a key tax benefit, as for all qualified plans, is that assets held in your personal ESOP account are not taxed until you actually receives a distribution from the plan. But what happens then?

Distribution of the assets from an ESOP is determined by the plan document. Publicly-traded companies typically distribute the stock to departing employees (some ESOP companies provide for limited in-service distributions but in most cases ESOP benefits are distributed after an employee leaves the company). Employees can then either hold the stock or sell it through a stock broker to the public markets.

Employees in closely-held companies must sell their shares back to the company sponsor, which is required to provide a market for the shares distributed to ESOP partcipants. To prepare for this “repurchase liability,” company's must prepare a financial plan to ensure that sufficient liquidity is available to repurchase the stock from departing ESOP participants. Recognizing the need of closely-held firms to balance the requirements of stock repurchases with using limited cash reserves to meet the ongoing requirements of the business, the law permits companies to defer distributions for the plan for a period of time.

For employees who leave a company prior to reaching retirement age, the plan sponsor is permitted to defer the distribution of the assets for up to five years after the end of the year in which the employee leaves the company. The payments may then be paid in equal annual installments of up to five years. In that scenario, it may be that an employee would not receive the full amount of the ESOP distribution for more than 10 years after leaving the company.

For employees who leave after reaching the retirement age as defined in the plan, the company must begin distributing the benefits no later than one year following the end of the year in which the employee separates from service. The distribution can either be in a lump sum or in equal annual installments not to exceed a period of five years.

Another benefit available to employees in ESOPs is that they can reduce their tax payments associated with the distribution of shares from the ESOP. Generally the amount subject to tax in a distribution from a qualified plan, including an ESOP, is the entire fair market value of the distribution, less the value of any employee after-tax contributions. However, when stock is distributed directly from the ESOP, the employee is only required to pay taxes on the cost basis of the shares distributed. This is allowed due to the special treatment accorded under the tax laws to Net Unrealized Appreciation (NUA). NUA is the difference between what the trustee(s) of a qualified retirement plan (including an ESOP) pays for the employer securities, and the fair market value of the securities at the time of distribution. Iif a distribution includes company stock, all or part of the NUA in the securities is excludable from income. This NUA is not recognized as taxable income until the recipient sells the securities. It is then characterized as a long-term capital gain, regardless of when the sale occurs.

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