What is an ESOP Distribution? How ESOP Retirement Benefit Payouts Work

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Tue, Oct 05, 2021
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Among the advantages of an employee stock ownership plan, the benefits to business owners and long-term cash and tax advantages to the company often receive most of the focus.

But it’s important to remember that an ESOP is a unique type of qualified retirement plan that can offer significant wealth-building benefits to employees.

ESOP companies may find it challenging to communicate their ESOP benefits to candidates and new employees. Clearly communicating the benefits of this retirement plan to prospective and current employees can help foster appreciation and strengthen ownership culture within an ESOP company.

With that goal in mind, here’s an overview of ESOP payout rules and the basics covering what employees can expect when it comes to their individual ESOP payments.

How Does an ESOP Distribution Work?

An ESOP is a defined contribution plan federally regulated by The Employee Retirement Income Security Act of 1974 (ERISA). Plan details can vary from one ESOP company to the next, but there are some general rules that all plans have to follow, by law.

The amount an employee will receive in an ESOP distribution is determined by how many shares have been allocated to them, the valuation of those shares, and whether the employee is fully vested in their account. Whether a company uses a graded vesting schedule or a cliff vesting schedule should be detailed in plan documents.

It’s especially important to understand that employees don’t contribute to their ESOP accounts. The ESOP company makes all contributions to this benefit plan.

How is an ESOP Payout Made to an Employee?

When a worker terminates employment, the company can make an ESOP distribution in stock shares, cash, or a combination of both. The cash portion, as one might expect, is paid out in cash. Often, company shares are repurchased by the ESOP, and the employee receives cash payment in the amount of the shares’ fair market value, as determined by the annual valuation.

In other cases, the company distributes shares directly to the terminated employee, who in turn has 60 days to sell the shares back to the ESOP for fair market value. If the employee believes the value will rise, they can choose to wait a year, after which they will have a second — and final — 60-day opportunity to sell back the shares.

The ESOP payment can be made in either a lump sum or in “substantially equal” installments over a five-year period. In cases where the employee balance is very large (over $1,165,000 in 2021), the five-year installment period can be extended to as much as 10 years.

How Soon is an ESOP Distribution Made After Employees Leave?

Regulations stipulate that the company has to distribute — in other words, payout — an employee’s ESOP account balance not later than a specified time after termination of employment. The allowed period of time after termination can vary, depending on employee age and the reason for leaving the company. These include:

  1. Employees who reach the plan’s normal retirement age (which can’t be older than 65), become disabled, or die must begin to receive distribution payments during the next plan year.
  2. Employees who terminate or are terminated for another reason must begin to receive distributions no later than six years after the plan year during which they left employment.

In the case of a leveraged ESOP, shares in an employee’s account that were purchased with an ESOP loan aren’t distributed until the loan is paid in full. Once the loan has been repaid, those distributions must be completed either by the plan year when the loan is repaid, or when the share distribution would have otherwise been completed — whichever is later.

ESOP Distributions Before Terminating Employment

Certain retirement plan rules can override ESOP rules. For example, employees over age 70-½ who are still working and in the plan must begin receiving distributions no later than April 1 of the calendar year, IF they own more than 5% of the company. 

ESOP regulations allow earlier distributions to enable employees to diversify their retirement investments. Employees with 10 or more years of plan participation and who are 55 or older can diversify up to 25% of the shares in their account each year, and up to 50% at 60 years old.

Different ESOPs can choose to pay out diversification distributions differently. Some companies may purchase shares for cash, and others may deposit the cash value in a 401(k) account and allow the employee to choose investments.

RELATED: What Employers & Administrators Need to Know About ESOP Distribution Timing

A few, but not all, ESOPs offer in-service distributions. Those that do, must offer in-service distributions equally to all employees.

ESOPs that are C corporations may directly pay employees stock dividends on the shares in their accounts. These payments are not distributions; they are earnings payments on the stock value.

Most ESOPs don’t allow employees to borrow from their plan account, as some 401(k) plans allow.

How Are ESOP Distributions Taxed?

Most often, distributions are taxed as ordinary income.

In the case of a lump-sum distribution in shares, the employee pays ordinary income tax on the value of the company’s contributions to the account, and additional capital gains tax on the appreciation in share value when the employee sells the shares.

Distributions before age 59-½ or for death, termination after age 55, or disability are subject to a 10% penalty tax. 

Employees can roll distributions over into a traditional IRA or another qualified retirement plan to defer taxation until the funds are withdrawn according to regulations. Those 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 later withdrawals in retirement would not be taxed, as long as Roth IRA rules are followed.

A rollover can be executed directly by the ESOP company, or the amount can be paid to the employee, who then has 60 days to roll it into an IRA before it becomes subject to penalty.

Learn More About ESOPs

The rules and regulations surrounding employee ownership and ESOP plans can be complex, but an expert explanation can make it a lot easier to understand the benefits, participation requirements, and rules for compliance. Our video, How Does an ESOP Work, is an excellent place to start. Click the link below to see for yourself.What is an ESOP and How Does It Work

Topics: distributions, ESOP Benefits

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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