How to Implement an ESOP: 5 Decisions You Need to Make
The deliberations are over: as a business owner, you have decided to implement an employee stock ownership plan (ESOP). Once you’ve gathered your trusted advisors and secured adequate financing, the last piece of the puzzle is to design the plan itself.
Although ESOPs are not one-size-fits-all, there are a few decisions every organization must make before the ESOP implementation process.
1. Determine Employee Eligibility
Which employees do you want included in your ESOP? Although the Internal Revenue Service (IRS) prevents employers from using ESOP eligibility requirements that are discriminatory in nature, you are entitled to restrict your participants by age and level of service.
- Age: If you would like, you can require employees to be at least 21 years old before they become eligible to participate in your ESOP.
- Service: You can grant employees entry to the plan immediately, or you can wait until they have completed one year or 1,000 hours of service, whichever is later. You can bump this service period condition to two years, but only if employees immediately vest at that two-year mark.
These ESOP eligibility limitations can be helpful if you have high turnover.
2. Determine ESOP Vesting Period
Being eligible to participate in an ESOP does not immediately grant employees the rights to the stock shares held in their accounts. Only when they are fully vested in the plan can they claim those benefits. Most employers use one of two vesting schedules:
- Three-Year Cliff: Employees are fully vested in the plan at the end of their third full-time year of service.
- Six-Year Graduated: Employees vest at 20% each year until they are fully vested at the end of their sixth year.
For even more flexibility, employers can elect to start the clock either when employees are first hired or when they first join the plan.
3. Determine Annual Contributions
Employers can contribute up to 25% of an employee’s annual compensation into an ESOP. Additionally, ESOP guidelines only consider participants’ first $280,000 of annual compensation (for tax year 2019) when calculating contributions. This constraint prevents the highest-earning employees – typically executives – from profiting from the plan at the expense of lower-paid employees.
In your plan documents, make sure you define annual compensation. There is flexibility in what compensation is included and not in a benefit plan.
4. Determine Distribution Standards
Your plan document should also outline your distribution method. Your methods may vary based on how and why the employee was terminated. ESOP distributions are made in the form of cash, stock, or a combination of both. Distributions can occur as a lump sum or equal payments over a period of no more than five years. As of 2019, that period can be extended based on limits imposed by the IRS.
5. Ensure Your ESOP Meets Regulatory Guidelines
Once you’ve drafted your plan document, your next step is to get it approved by the IRS. If your plan meets regulatory standards, the IRS will give you the “qualified” stamp of approval. When you have a qualified plan in the eyes of the IRS, both the costs of and the contributions to your plan are deductible. A professional should review your plan document before you submit it for approval, but a good place to start is with the IRS’s ESOP checklist.
A qualified plan must also abide by the Employee Retirement Information Security Act of 1974 (ERISA). ERISA requires your plan to be overseen by a trustee willing to fulfill four distinct fiduciary duties:
- Duty of Loyalty: The trustee must act solely in the interest of plan participants and beneficiaries, not in the interest of the company or its owners.
- Duty of Prudence: The trustee must act as a prudent expert.
- Duty to Follow Plan Terms: The trustee must follow the plan and trust provisions unless those provisions are contrary to ERISA guidelines.
- Exclusive Purpose Duty: The trustee must act for the exclusive purpose of providing benefits to company employees, not for personal gain or any other purpose.
Trustees should take their placements seriously; they will be held personally liable for plan losses that result from their breach of duty.
Trustees can be either internal or external to the organization. Internal trustees may find it difficult to fulfill their fiduciary duties because of their inherent conflicts of interests. They may feel pressure from management to act a certain way but be bound by ERISA to make a different move. Although internal trustees are more economical, it may be easiest to outsource such an important job.
External trustees, when chosen correctly, can easily meet the “duty of prudence” standard and will have experience complying with ESOPs’ ever-changing rules.
As you work through the ESOP implementation process, talk to your trusted advisor for their advice and experience. We look forward to hearing from you.