ESOP vs ESPP: How Do These Employee Stock Benefit Plans Differ?

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Tue, Jul 27, 2021
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Employee stock ownership plans (ESOPs) and employee stock purchase plans (ESPPs) are both employee benefit plans that companies use to extend ownership benefits to employees. ESOPs and ESPPs both offer employers ways to help employees grow their retirement savings and build wealth.

In addition, both of these employee benefit plans can be powerful tools to promote employee engagement and a sense of shared culture and aligned values. Employees with an ownership stake in the business may be more attentive to the shared company vision and culture. That, in turn, can have positive effects on recruiting and retention, productivity, and long-term company success.

Despite their similar names, these two types of employee ownership benefits are quite different from one another. An ESOP is a qualified defined contribution retirement plan, so employees don’t purchase shares with their own money. An ESPP, on the other hand, is a plan that allows employees to use their own money to buy company shares at a discount.

In this article, we’ll compare ESOPs and ESPPs and clarify the distinctions between them.

ESPPs vs. ESOPs: Ownership and Taxation

In an ESPP, employees can choose to participate via payroll deduction to purchase company stock at a discounted price. Employees designate a percentage of income to be set aside and used to purchase company stock at a discount, at specified intervals.

ESPPs can be either qualified or nonqualified plans. In qualified ESPPs, employees are not taxed on the discount at the time when they buy stock. Instead, they later pay capital gains on the profits realized when they sell their shares. In nonqualified ESPPs, the difference between employee stock price and fair market value at purchase is taxed as ordinary income.

In either case, employees use their own money to purchase company stock in publicly traded companies, and shareholders who already own more than 5% of company stock are not eligible to participate in a company ESPP.

An ESOP, on the other hand, is always a qualified retirement plan. An ESOP is a defined contribution plan that rewards employees by proffering the value of stock ownership interest in the company over time. That is to say, ESOP employees don’t purchase shares using their own money. Rather, the ESOP company allocates stock ownership to employees via an ESOP trust, which holds the stock on employees’ behalf.

Stock value is earned and apportioned annually. When an ESOP employee retires or separates, the ESOP trust “buys back” the employee’s vested company stock at the current stock valuation price, and the employee is taxed on the stock value at that time.

At a Glance: Employee Stock Purchase Plan vs. ESOP

Attributes ESPP ESOP
Who pays for stock purchases? Employees Company contributes tax-deductible shares to ESOP trust
Do employees have access to stock accounts before retirement or separation? Yes No
What are the costs to establish and administer? Lower Higher
Which is used by public or private companies? Common in publicly held companies Common in closely held companies, sometimes used by public companies
When are participants taxed? When shares are sold At retirement
Can employees take shares with them? Yes No

 

An ESOP is More Than a Qualified Retirement Plan

An ESOP can also be an attractive exit strategy for a departing business owner. In a closely held private company, an ESOP can be created to purchase some or all of an owner’s shares, providing liquidity to the seller and attractive tax and cash advantages to the company. The departing owner can choose what percentage of shares to sell, up to 100%. This flexibility enables lifelong business owners to diversify their wealth in advance of retirement. 

In addition, business owners who sell more than 30% of their C corporation stock to an ESOP can defer capital gains on the sale. While proceeds from the sale of S corporation stock are taxed as capital gains, that compares favorably with the likelihood of paying a combination of income tax and capital gains on a typical third party sale.

Finally, selling a business to an ESOP empowers the seller to control their exit and remain in their position of leadership as long as they choose. This allows for a carefully planned and executed leadership succession, continuity of company culture, and even the opportunity for the seller to earn a fresh ownership stake as an employee participant in the ESOP defined contribution plan.

Discover the Powerful Advantages of an ESOP

Extending ownership stakes to employees while offering a controlled exit to the business owner are key advantages of an ESOP that support a smooth transition and ongoing success of the company. But the advantages don’t end there. An ESOP’s unique tax advantages can increase cash flow, creating a competitive edge for the company.

Learn about these advantages and more when you download our free eBook, Key Benefits of Incorporating an ESOP into Your Business Exit Strategy. You’ll see how an ESOP creates a friendly buyer for the sale of your business, can allow an owner to defer or avoid taxation on the business sale, and more. Just click the link below to download your copy.

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Topics: ESOP Benefits, Business Succession Planning

Aaron Juckett, CPA, CPC, QPA, QKA
Written by Aaron Juckett, CPA, CPC, QPA, QKA

Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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