Some companies provide their employees with an opportunity to purchase company stock. Not only does it benefit employees, but it also encourages employee ownership in the company. That ownership can enhance worker retention and incentivize employees to be more productive in their jobs.
Two popular options for company stock ownership are the Employee Stock Ownership Plan (ESOP) and the Employee Stock Purchase Plan (ESPP). But what exactly are ESOPs and ESPPs, and should you participate in a plan if your employer offers one?
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Employee Stock Ownership Plans (ESOPs)
An ESOP is a program designed to transfer ownership of a company to the employees. Though ESOPs can be offered to employees of large, publicly traded companies, they are more popular among small, privately held companies.
An ESOP functions something like a 401(k) plan. Contributions are made to an account; however, the sole investment offered is company stock. In most cases, the employer makes 100% of the contribution and the funds and stock held in the plan are held in a trust on the employee’s behalf.
Total ESOP plan contributions per employee are limited to $275,000 in 2024.
If the company makes contributions on the employee’s behalf, ownership of the plan is subject to vesting rules. Typically, this will include gradual ownership, rising from 20% after one year to 100% after five years of participation. This is similar to how employer matching contributions on 401(k) plans work, and ESOPs commonly function as a retirement plan.
The employee can sell his or her vested interest in the plan at the time of separation from the employer. At that time, the employer repurchases the stock in the plan. The shares are sold back to the employer at the then fair market value. ESOP proceeds can also be rolled over into an IRA.
Employee Stock Purchase Plans (ESPPs)
An ESPP is an employer benefit plan offered by publicly traded companies, enabling employees to purchase stock in the company at a discount of up to 15%.
Employees can make contributions of up to 10% of their earnings with the company, up to a maximum annual contribution of $25,000. Contributions are made through payroll deductions, though those deductions are not tax-deductible. As funds accumulate in the plan, the employee can purchase company stock when it is offered by the employer. This will be done periodically, either quarterly, semiannually, or annually.
Once an offering is made, employees will have a specific amount of time to purchase the stock. This is referred to as the offering period. It can be anywhere from several months to a couple of years.
The market price that will apply to the stock purchase is determined either on the offering date or the date of purchase. Some employers may allow the purchase to be made at the lower of the two dates.
✨ Related: What is an ESPP and Should I Participate in One?
How Does Each Plan Work?
How Do ESOPs Work?
ESOPs work much the same way as 401(k) plans do. If the employee makes contributions to the plan, the amount of the contributions is tax-deductible in the year they are made.
No tax liability is incurred while the employee is participating in the plan. However, when the employee separates from the employer and takes distributions from the plan, those distributions become taxable (see Tax Consequences – ESOP below).
Unlike 401(k) plans, ESOPs are designed to hold only stock in the employing company. However, they are designed to be long-term investment plans, with all benefits occurring only after the employee separates from the company. This is unlike ESPPs, which allow for regular and immediate benefits from the purchase and sale of company stock on an ongoing basis.
When an employee takes distributions from an ESOP, which can only happen when the employee dies, retires, quits, or is fired, the vested portion of the plan will be distributed to the employee in the form of cash. The employee does not take stock distributions from the plan.
The plan distribution can either be a single lump sum payout or spread over several years.
How Do ESPPs Work?
Employers offer company stock to be sold at a stated discount (up to 15%) on a specified date. Eligible employees then contribute after-tax income to a fund that will be used to buy the stock on the date it is available for sale. Depending on the plan, employees can then sell the stock for an immediate profit, or hold it for the promise of future growth.
Participation in an ESPP is open to all employees who meet the minimum employment requirement. That can be anywhere from one month to one year. However, ESPP participation excludes employees who own more than 5% of the company’s stock.
Though the maximum discount allowed is 15%, an employer can set the percentage at a lower rate.
Qualified vs. Non-qualified ESPPs: An ESPP can either be a qualified or non-qualified plan. A qualified ESPP requires the approval of company shareholders. If the plan is qualified, the offering period must be three years or less, and the maximum share price is limited. Non-qualified ESPPs have fewer restrictions but do not have the tax advantages offered under qualified plans.
Tax Implications of ESOPs and ESPPs
Tax Implications of ESOPs
The tax consequences of an ESOP are simple compared to an ESPP. There are no tax consequences while the plan is in effect and the employee is participating in it. The entire tax consideration occurs only when the employee either retires or leaves the company.
Treatment of distributions from the plan is similar to that of 401(k) plans and other retirement arrangements. Funds distributed from an ESOP become taxable when paid out. If the distribution occurs after the employee reaches age 59 ½, the funds withdrawn will be subject only to ordinary income tax.
If the funds are withdrawn before the employee reaches age 59 ½, the distribution will be subject to both ordinary income tax and the 10% early withdrawal penalty tax.
Tax Implications of ESPPs
Due to the purchase discount, taxes on ESPPs can be complicated.
With a non-qualified plan, the amount of the discount is taxed as income in the year when the stock is purchased. The employer will withhold applicable federal income tax on the dollar amount of the discount. When the stock is sold, the difference in price between the market value at the time of purchase and sale price is treated as capital gains.
In a qualified plan, there are no tax consequences in the year of purchase, instead taxes are due in the year the stock is sold. The difference between the purchase price and the sale price will be treated as capital gains.
Depending on the rules of the plan, an employee can either sell the stock immediately after purchase, generating an immediate gain on the discounted price or hold the stock longer in anticipation of a still higher future price.
When You Should Sell ESOP or ESPP Shares
When to Sell in an ESOPs
Under an ESOP plan, the employee generally does not have the option to sell company stock. Instead, the stock remains intact in the plan until the employee separates from the employer and chooses to take a distribution from the plan.
Distributions are paid out in cash, as stock is liquidated within the plan before being dispersed. The employee does not have the option to take distributions from the plan in the form of stock.
When to Sell in an ESPPs
If the employee wishes to lock in an immediate gain on the sale of the stock purchase, the stock can be sold immediately upon purchase, although some plans require a designated holding period.
However, if the employee believes the stock price will continue to grow in the future, he or she can choose to hold onto the stock longer. The potential gains will be higher if the stock does increase in value. There is also a benefit of lower long-term capital gains tax rates if the stock is held for over one year before being sold.
The biggest disadvantage of an ESPP is that the funds contributed to the plan come out of after-tax earnings. That means the employee will experience an immediate reduction in net pay for the full contribution amount. That can create an immediate cash flow problem, but there is a workaround.
If you don’t have the funds, you can use a service like Benny, which can advance you the amount of the contribution. Repayment will be collected once the stock is sold. Benny will charge a fee of 20% of the gain on sale, which will be 20% of the discount amount if the stock is sold immediately after purchase.
Final Thoughts
ESOPs and ESPPs are employee benefits that you should take advantage of if either plan is offered by your company.
Though the ESOP does not offer any immediate benefit, it does enable you to build up a large nest egg, either for retirement or the day when you separate from your employer.
Since they are usually fully funded by the company, you can participate in the plan at no cost to you. That makes it a found money arrangement. Just be sure you remain employed by the sponsoring company long enough to become fully vested in the plan to get the maximum benefit.
ESPPs are usually not as generous as ESOPs dollar-wise, nor are they suitable as retirement plans (due to their lack of deferred taxation). But they do offer an opportunity for you to gain an immediate and ongoing benefit from the sale of company stock as you make purchases in the plan. Just be sure to be prepared for any tax liability that will be generated by your participation.
If you have an opportunity to participate in either an ESOP or an ESPP, you should consult with an accountant or other tax professional to make sure you are fully aware of any tax consequences and can plan accordingly.
