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An employee stock ownership plan (ESOP) is a unique qualified benefit plan and ownership transition tool that enables shareholders of closely held companies to tap into the value of their equity while extending an ownership interest to employees.

Here’s how an ESOP works:

Annually, the ESOP-owned company can contribute shares to the plan, the ESOP trust can purchase company stock using cash in the plan, and/or shares can be released from a suspense account as loan payments are made throughout the year prior to the allocation date.

Those shares are then allocated by the plan to eligible employees’ individual retirement plan accounts.

When an ESOP participant retires or leaves the company, he or she receives an ESOP distribution in the form of a payment from the company for the fair market value of the vested shares in his or her account. 

ALSO READ: Top 5 Facts About ESOP Account Vesting Your Participants Need to Know

But how do ESOPs fairly determine individual employees’ ESOP allocations? Most often, the individual employee’s shares are allocated in proportion to their eligible compensation. But what does that mean in practice, and is it always the case?

Let’s take a closer look.

Who Can Participate in the ESOP and Receive Shares?

Generally, all full-time employees aged 21 and over who have completed a year of full-time service are allowed to participate, with some exceptions. ESOPs may choose to include younger employees, and they may also choose to allow participation earlier. Plan entry can be delayed to two years, with immediate full vesting.

Exceptions include employees with collective bargaining, independent contractors, nonresident aliens, leased employees, and employees of related employers. Learn more about eligibility requirements here.

How Does the ESOP Ensure Allocations Are Fair?

Internal Revenue Code (IRC) minimum coverage requirements outlined in Section 401(a)(4) prevent ESOPs from disproportionately benefiting highly compensated employees (HCEs). 

According to IRC rules, the percentage of non-highly compensated employees covered by an ESOP must be at least 70% of the percentage of HCEs benefiting from the plan, and the plan must be able to demonstrate that allocations do not discriminate in favor of HCEs.

A highly compensated employee is:

  1. A person who owned more than 5% of the interest in the business during the current plan year or the preceding (lookback) year, regardless of the compensation he or she earned or received, or 
  2. A person who the previous year received compensation from the business of $130,000 or more in 2020 or 2021 and $135,000 or more in 2022. 

An employer may also choose to consider employees HCEs if they rank among the top 20% by compensation within the company.

Factors that Can Affect ESOP Allocations


Compensation Needs to be Defined

Most ESOP allocation formulas distribute shares in proportion to employee compensation, so higher-paid employees receive a higher percentage of the year’s contribution than lower-paid employees. Allocation formulas may also take employee tenure into account. Some ESOPs are designed to allocate shares in rate groups or some other formula to achieve more equal allocation, but the allocation formula is part of the plan design, which is subject to IRS review and determination.

The IRS uses an ESOP’s definition of compensation to evaluate whether it meets requirements for qualified plans — that is, whether the ESOP maintains its tax-advantaged status.

The annual maximum deductible ESOP contribution is based on the participants’ aggregate eligible compensation, and the maximum annual allocation to a participant’s account is based on his or her eligible annual compensation, up to a limit of $305,000 for 2022. In general, ESOP-owned C corporations can deduct up to 25% of participants’ eligible compensation per year, up to a maximum of $61,000 for 2022 for a non-leveraged plan.

Disqualified Persons and Non-Allocation Years

IRC Section 409(p) requires ESOP plan documents to include language expressly stating that no portion of employer stock held by an S corporation ESOP may be allocated to a disqualified person during a non-allocation year.

Ensuring Your Plan Meets Requirements

An ESOP’s tax advantages are directly tied to its compliance with regulatory requirements. A failure to comply can result in a loss of tax-advantaged status, with potentially devastating consequences to the company and its employees. You can take steps to ensure that your plan documents include a clear and compliant ESOP distribution policy that articulates timing, form, and method of distributions to plan participants. Click the link below to claim your copy.

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