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ESOP Distributions – What Are They and How Do They Work?

By December 5, 2022No Comments

One of the main advantages of an Employee Stock Ownership Plan (ESOP) is its ability to link an important retirement benefit for your employees to overall company performance. At the end of their tenure with your company, vested employees will get an ESOP distribution – the size of which depends on the overall value of the company and the amount of ESOP shares a given employee holds. In effect, this meaningful wealth-building tool for loyal employees not only helps your company attract and retain talent, it also aligns your employees’ long-term financial goals with your company’s financial performance.

In this article, we’ll answer some of the most common – and important – questions about how ESOP distributions work, when they pay out, what the tax treatment is, and more.

  1. What is an ESOP Distribution? 

An ESOP is a federally regulated retirement plan under The Employment Retirement Income Security Act of 1974, commonly known as ERISA. Essentially, an ESOP provides each employee with their own ESOP retirement account which, in most cases, the employee does not contribute to directly.

Instead, the company makes contributions to the ESOP benefit plan on the employee’s behalf, and the value is determined by the number of shares allocated to the employee, the valuation of the shares, and whether they are fully vested or not. Companies use either a cliff vesting or graded vesting schedule to determine this.

  1. When are ESOP Distributions made?

After an employee meets the minimum threshold for vesting, they will receive their ESOP distribution when they terminate their employment with their employer. Employees who leave before becoming vested will forfeit any non-vested benefits, which are then typically reallocated to remaining ESOP participants.

Typically, when an ESOP participant’s employment is terminated due to retirement, disability, or death, the ESOP begins distributing the vested benefits during the plan year following the year of the event.

If an employee terminates or is terminated, they receive disbursements following the 5th break in service which could be 5 years or 6 years following termination. However, there may be other restrictions, such as waiting until the internal note is completely repaid. There also may be an earlier distribution date if the plan specifies that they can receive it no later than the earlier of a) 10 years of participation in the plan (active & inactive), b) reaching normal retirement age, or c) termination. If the terminated participant is at least age 72, they must take a minimum distribution that is taxable. If the ESOP plan balance is more than the cash-out option, they may opt to defer until retirement age.

Ultimately, the ESOP plan document will specify the timeline of benefits after termination of employment.

  1. How are ESOP Distributions paid to employees?

ESOP Distributions are made in cash, stock shares, or a combination of both. Usually, they are done in lump sums, or in installments not more than five years, unless the balance exceeds the IRS payout limit which then allows additional years with an increment.

With the cash option, the shares may be repurchased or retired by the ESOP with the employee receiving a cash payment based on their number of shares and the value of the shares as determined by an annual valuation.

If the employee receives the stock options, the company distributes the shares directly to the exiting employee who then has 60 days to sell the shares back at fair market value, or can choose to wait a year before selling if they feel that the stock value will rise.

  1. How are ESOP Distributions Taxed?

Once the ESOP funds are distributed, the former employee is taxed at ordinary income tax levels on the value of the company’s contributions.  If the participant elects to take the distribution as a cash distribution it will be reported on a 1099-R.  Then there is an additional capital gains tax on the appreciation of value after selling the shares if taken as a stock distribution, and the participant will be issued a 1099 from the company.

Like regular retirement plans, distributions before age 59-½ are subject to a 10% penalty tax. Employees can avoid the tax penalties by rolling over their distributions into a traditional IRA or another qualified retirement plan. The later withdrawals are taxed as ordinary income. An employee who rolls over an ESOP distribution to a Roth IRA would pay tax at distribution, and then avoid taxes on it later.  Cash distributions have an immediate 20% federal withholding

  1. Can ESOP Distributions occur before termination?

Distributions may also be allowed while the participant is still employed. These diversification payments are allowed once the participant meets the requirements of a Qualified Participant, determined by IRS Code 401(a)(28). Diversification distributions are usually a cash or stock distribution (a taxable event) or a distribution to another qualified plan, often a company 401(k) plan.

If the participant has reached the age of 72, is still working, and owns more than 5% of the company they must start to receive distributions no later than April 1 of that calendar year. If the participant owns less than 5% of the company, they can defer the required minimum distribution.

Employees who are 55 or older with 10 or more years of ESOP participation will have the option to diversify up to 25% during the 1st five years and up to 50%, cumulatively, in the 6th year.

An ESOP retirement plan is an important mechanism that helps drive company performance, rewards employee contributions, and provides owners and founders with an alternative exit strategy that ensures business continuity. For more information, contact us today for a free ESOP consultation to see if an ESOP is right for your company.