How Do ESOPs Work?

A company which wants to set up an ESOP creates a trust to which it makes annual contributions. These contributions are allocated to individual employee accounts within the trust. A number of different formulas may be used for allocation. The most common is allocation in proportion to compensation, but formulas allocating stock according to years of service, some combination of compensation and years of service, and equally, have all been used. Typically employees might join the plan and begin receiving allocations after completing one year of service with the company, where any year in which an employee works at least 1000 hours is counted as a year of service.

The shares of company stock and other plan assets allocated to employees' accounts must vest before employees are entitled to receive them. Vesting is a process whereby employees become entitled to an increasing percentage of their accounts over time. (The rules governing vesting and protection of accrued benefits are found in IRC Section 411.)

The Pension Protection Act (PPA) of 2006 modified the vesting requirements applicable to all employer contributions to defined contribution plans. The provisions of PPA provide that any contributions made in plan years beginning after December 31, 2006 must vest under either the three year cliff or six year graded schedules. Thus, all employer contributions, not just matching contributions must vest under the three year cliff or six year graded vesting schedules.

Three Year Cliff
Years of Service                    Vested Percentage
Less than 3                                            0%
3 or more                                           100%

Six Year Graded
Years of Service                    Vested Percentage
Less than 2                                             0%
2                                                          20%
3                                                          40%
4                                                          60%
5                                                          80%
6 or more                                           100%

Pre-2007 vesting schedules were the five year cliff vesting schedule and the seven year graded vesting schedule. For benefits accrued related to years from 1998 to 2006, benefits must generally vest at least as quickly as one of the two schedules above.

When an ESOP employee who has at least ten years of participation in the ESOP reaches age 55, he or she must be given the option of diversifying his/her ESOP account up to 25% of the value. This option continues until age sixty, at which time the employee has a one-time option to diversify up to 50% of his/her account.

Employees receive the vested portion of their accounts at either termination, disability, death, or retirement. These distributions may be made in a lump sum or in installments over a period of years. If employees become disabled or die, they or their beneficiaries receive the vested portion of their ESOP accounts right away.

In a publicly-traded company employees may sell their distributed shares on the market.  The form of distribution of a privately held firm can vary, depending on the plan document or whether the ESOP sponsor is an S corporation, or all or substantially owned by the ESOP with bylaws that only authorize company stock be owned by employees.  For example, an S corporation does not have to make distributions in stock.  But if privately held, the company makes the distribution in stock, it must give the employees a put option on the stock for 60 days after the distribution.  If the employee chooses not to sell at that time, the company must offer another put option for a second sixty day period starting one year after the distribution date.  After this period the company has no further obligation to repurchase the shares.

An ESOP company may make an "installment distribution," provided that it makes the payments in substantially equal amounts, and over a period to start within one year for a retirement distribution, within five years for a pre-retirement distribution, and not to exceed five years in duration in either case. The company must provide "adequate security" and pay interest to the ESOP participant on the unpaid balance of an installment distribution.