An employee stock ownership plan (ESOP) is a uniquely powerful employer-sponsored qualified benefit plan.
That's because an ESOP offers business-building tax advantages while employees earn ownership stakes in the company to build their own retirement wealth.
The ESOP-owned company allocates stock to eligible employees’ ESOP accounts on an annual basis. After vested employees leave the company, they receive retirement benefits in the form of ESOP distributions.
When you help employees understand how their ESOP benefits work, you’ll cultivate a deeper appreciation for your company’s culture of ownership — not to mention the retirement wealth they can earn.
In this article, we’ll review the different types of ESOP distributions and the rules that apply to them, and help you answer some of the most common questions employees often have about their participation in an ESOP, including these ESOP basics:
- ESOP distribution definition
- When ESOP distributions take place
- How an ESOP distribution works
- How and when ESOPs pay out employee distributions
- How ESOP distributions are taxed
ESOP Distribution: Definition & Payout Rules
Plan designs vary, so ESOPs can have differences in eligibility requirements, vesting schedules, and distribution policies. But all ESOPs are federally regulated by the Employee Retirement Income Security Act of 1974 (ERISA) and must comply with regulations enforced by the Internal Revenue Service (IRS) and Department of Labor (DOL).
What is an ESOP Distribution?
An ESOP distribution is the disbursement of a plan participant’s accumulated ESOP retirement benefits. It may be due to retirement, termination, death, or disability. It may be made in cash, shares of company stock, or a combination of both.
The plan document and distribution policy explain the timing, form, and method. The ESOP’s plan document and distribution policy are reviewed by the IRS for the plan to become tax-qualified.
How to Determine & Document an Effective ESOP Distribution Policy
Take steps now to ensure that your ESOP’s distribution policy is effectively supporting the success of your plan and the future of your ESOP-owned company.
When Can ESOP Distributions Be Made?
Generally, ESOP participants qualify for a distribution for one of these reasons:*
- Retirement (at or after age 59-½)
- Death or disability
- After terminating employment for another reason
- After reaching age 73 (in 2023; RMD age will increase to 75 in 2033)
- After an employee meets certain age and service requirements and elects to diversify (if the ESOP includes an option for cash or stock distribution for diversification)
*Note: ESOPs are allowed, but not required, to offer hardship distributions. In those cases, the IRS may waive the 10 percent excise tax if the distribution is taken to cover expenses that qualify as financial hardship, such as medical, funeral, or tuition expenses, and costs paid to avoid foreclosure. While it may not be subject to the excise penalty, a hardship distribution is taxed as ordinary income.
How Does an ESOP Distribution Work?
Because it’s subject to ERISA law, an ESOP must meet specific requirements to maintain its tax-qualified status. Among those requirements are a plan document and a distribution policy. These documents cover the ESOP’s established policies and processes, including vesting schedules (whether graded or cliff vesting), payout options, and lump sum thresholds.
How long does it take to receive an ESOP distribution payment? Requirements for when vested participants receive distributions depend on the reason for their exit. ESOPs must offer to start payouts no later than:
- One year after the close of the plan year following retirement, disability, or death; or
- The sixth plan year after the plan year during which the participant terminates employment for another reason
The amount of an employee’s ESOP distribution is based on three factors:
- Number of shares allocated to the participant
- Value per share
- Whether the employee is fully or partially vested in their ESOP account
Internal Revenue Code (IRC) Section 409(o)(1)(B) makes an exception for leveraged ESOPs to defer distribution payments until the close of the plan year during which the loan is paid in full. Once the loan has been repaid, outstanding distributions must be completed by the end of the plan year in which the loan is repaid, or the plan year when the share distribution would otherwise have been completed — whichever is later.
How and When is an ESOP Payout Made to an Employee?
After the employee terminates, the company can make the distribution in shares, cash, or some of both. Cash is paid to the employee directly. Often, company shares are immediately repurchased by the ESOP, and the employee receives cash equivalent to fair market value as determined by the most recent annual valuation.
In other cases, the company distributes the employee’s shares directly to them. The employee, in turn, then has 60 days to sell the ESOP shares back. This put option period is outlined in IRC Section 409(h).
If the employee believes the share value will rise at the company’s next annual valuation, they may opt to wait a year. After that year, the former employee will have a second — and final — opportunity to sell their shares.
Payment for the participant’s distribution can be made either in a lump sum or in “substantially equal” installments over a period of five years. If the balance is very large (over $1,330,000 in 2023), the five-year installment period can be extended to as long as 10 years. Depending on the date of termination and the ESOP’s annual reporting period, it may take up to nearly 11 years to complete the distribution payout.
Can Employees Take ESOP Distributions While Still Working?
ESOP Distributions Before Terminating Employment
Certain rules for retirement plans in general can supersede ESOP-specific rules. For example, employee owners with more than 5% company ownership who are still working at the company on their 73rd birthday are required to begin taking distributions no later than April 1 of the next calendar year. In other cases, 5%-or-more owners’ distributions must start no later than April 1 of the calendar year following their retirement.
In-Service Distributions for Diversification
Participants can qualify for diversification after completing at least 10 years of plan participation and reaching their 55th birthday. If the fair market value of the participant’s account balance is less than $500, the ESOP is not required to offer the opportunity to diversify. Qualified employees can elect to diversify up to 25% of the shares in their account each year, and up to 50% at age 60.
The plan document and distribution policy articulates how the ESOP pays out diversification distributions. While one may pay fair market value in cash to purchase the shares, another company may choose to deposit cash value in a 401(k) account and allow the employee to choose investment.
A few — certainly not all — ESOPs offer in-service distributions. Those that do so must offer in-service distributions equally to all employees. And unlike some 401(k) plans, the vast majority of ESOPs don’t allow participant loans.
What About ESOP Dividend Payments?
ESOPs that are C corporations may directly pay employees stock dividends on the shares in their ESOP accounts. Dividends paid on shares aren’t considered distributions. Referred to as pass-through dividends, they’re earnings payments, and they’re not subject to the notification and consent rules of distribution payouts.
How Are ESOP Distributions Taxed?
Most of the time, ESOP distributions are taxed at ordinary income tax rates.
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 wouldn't be taxed, as long as Roth IRA rules are followed.
The company can execute the rollover directly, or the amount may be paid directly to the employee, who has 60 days within which to roll the funds into an IRA before the distribution becomes subject to penalty.
Does Your ESOP Have a Clear & Compliant Distribution Policy?
An ESOP’s distribution policy should protect participants and the plan—so it’s vital to give extraordinary care and attention to its development and communication. Our guide, How to Create an ESOP Distribution Policy, can help your team get started. Click below to claim your free copy.