Employee Stock Option Program (ESOP)
Organizations can establish an ESOP to grant their employees with stock options in the company. These programs are designed to increase the employee’s stake or ownership of the company. This is a great way for an employee to make a long-term commitment and financial commitment to their employer.
Although this type of plan has many aspects that are advantageous, it also has some disadvantages. For example, ESOPs that have high strike prices may discourage individuals from exercising their options if they want to diversify their investments or want quick liquidity for a particular need, like buying a home.
The organization needs to be careful when using stock options in a ESOP because if they are not properly structured, it may result in discriminatory actions and penalties. This is the business equivalent of selling the same product differently. In this case, stock options are being used as some form of equity compensation. To make a long story short, discrimination can occur if the company’s goals and objectives are not aligned with the employee’s goals and objectives.
Stock options have become major issues at many companies due to their potential for misuse or abuse in employee benefit plans. The key to controlling these problems is to understand how they work and how employees use them. The majority of the problems can be attributed to “non-qualified stock option plans” or less commonly called “contingent plans.” Nonqualified stock options are options granted to underperforming employees, typically when they have been terminated from the company or not retained for a number of months.
There are three types of ESOPs:
Nonqualified Plans : The first type is nonqualified plans or what employers refer to as “contingent” plans, which give employees the right at some point in the future to purchase a portion of their employer’s shares. In these plans, employees do not receive vested shares unless and until they exercise their options or invest more money into the plan.
In Nonqualified Plans, the employees do not have ownership rights. However, there are some countries that allow nonqualified plans to be used as a group retirement plan up to a certain dollar amount. This type of plan is non-discriminatory in nature and can be provided by employers of any size.
Qualified Plans : The type of plan you probably think when you hear the term “ESOP.” In qualified plans, employees receive vested shares in their accounts very soon after they are granted stock options. These vested shares are eligible for a tax-free rollover into an IRA or another qualified retirement plan.
Qualified plans are used for compensating staff and managing retirement programs. Qualified plans are also known as 401ks in the US. However, due to the age of qualified plans, and their restrictive rules, there have been a significant number of loopholes over the years. This has led to over 250 million dollars in mis-reported compensation each year.
Nonqualified Deferred Compensation : The last type of ESOP is a nonqualified deferred compensation plan. There are many of these plans floating around out there that some companies structure them with an ESOP attached to their money-purchase pension plan or any kind of non-qualified plan that falls short of an IRS approved qualified plan.
An ESOP is a financial contract. While it may appear that there are few moving parts to an ESOP, the further you dig into the details of these plans, the more complex they become.
One of the biggest mistakes that employers make when they sponsor a nonqualified plan is to assume that it gets off cheap by putting only 5 percent of their assets in their plan or by funding the plan only a nominal amount each year. What many employers fail to realize is that when their stock rises in value, and employees exercise their options to buy company stock at a bargain price, all other things being equal, they will have to take less money out of their business than if they funded more up front.
The reason for this is that when an employee purchases company stock, he or she receives a tax deduction for the entire amount paid out. It is also important to note that payments to employees under this plan do not qualify for the 10-year limitation provided under Internal Revenue Code section 83(b)(6).
Companies with very small ESOP programs often mistakenly believe that they can get by using a relatively small amount of assets to fund the plan. At least $1 million in assets are required to support an ESOP.
Over time, many of these companies find themselves unable to compete with the larger companies operating ESOP plans, and are forced to close their doors. Those who continue in business have a difficult time competing against them because they do not have the expertise or the funding to address the legal issues that crop up. In fact, some larger ESOP participants (with assets between $5 million and $25 million) have been forced to restructure their plans due to mismanagement or erroneous assumptions.
It is generally accepted that each year the assets in an ESOP must be $1 million or more. If you intend to have a U.S. ESOP, be sure to do your homework and understand how this type of plan works. All too often, companies find that they do not understand the rules associated with an ESOP and end up in trouble with the law.
If you decide to develop an ESOP for your business, or if you already have one, it is important to be aware of the following:
Restrictions imposed by the tax code itself; The state where your business is located; Regulations imposed by your company’s industry; and Your state government’s legal requirements for qualified plans.
Many employers mistakenly believe that they can get away with having a small ESOP program. The truth is that even for the smallest ESOP program, there are many moving parts that must be addressed. Some of these items include:
Securities and Exchange Commission (SEC) regulations; Requirements imposed by your State’s Department of Insurance; Withholding requirements imposed by the Internal Revenue Service; and Your State’s Department of Labor.
U.S. employees are required to pay federal income taxes on their portion of company stock at the time it is sold. If any unvested stock is sold, no tax is due until such time as they vest in accordance with IRS rules (See U.S. Taxation of Employee Stock Options).
As a rule, all U.S. companies wanting to offer their employees the opportunity to purchase stock at an attractive price should work with an accounting firm that has experience in managing ESOPs. The accountants will be responsible for keeping careful track of when options are exercised, how much stock is purchased (grossed up), how often money is paid out in salary or bonuses and when payments to employees are made (gross up).
If you get around this issue, and if you understand your state’s tax laws regarding ESOPs, then you’ve just about got it made. However, if you get into trouble in this area, or if you don’t complete your paperwork and don’t have an ESOP at all, you could face serious legal consequences.
If you want to be an ESOP provider, there are a lot of details that need to be taken care of as soon as possible—before your plan runs afoul of the law. Fortunately for those who are looking to create an employee stock ownership plan (ESOP), there are various documents that can help with the process.
Some of the most important documents that you will need are:
1. The Employee Stock Ownership Plan (ESOP) Agreement: An agreement that details the basics of your ESOP and how it will work. Although you can use a template to create your plan, it is important to get an agreement in writing with all pertinent terms spelled out per the law.
2. The Transfer and rolling over of stock: As an ESOP provider, you are responsible for instructing employees on how they should transfer their shares to your plan for purchase by others who want their stock in the form of employer stock purchases (ESPPs). Make sure to follow all of the state and federal ESOP laws, as this is where you will run into trouble. These laws vary from state to state, so there is no centralized guideline. You should call the legal department of your plan sponsor if you have any questions.
3. The Superannuation Trust: This document includes the rules that govern your plan and how money will be invested (i.e., in an ESOP or other investment).
4. The Retirement Plan regulations: This involves an overview of your plan and how it views retirement investments (i.e., whether it qualifies as a Roth 401(k) or IRA).
5. The Participation agreement: This is an agreement that details how your employees will participate in the plan.
6. The Stock Redemption Agreement: A copy of a contract with a third-party company to act as custodian.
7. The Proxy Agreement/Processes: Your employees must follow certain procedures, or they may not be able to take part in the plan; they need to know what their rights are and how they can use them, as well as what happens if someone does not behave properly according to the agreement.
8. The Employee Benefits Summary: A list of all the benefits that your employees are eligible for, including the ESPP, pension plan, annuity plan, and other features of your company. Make sure that you have a summary of these documents available to your employees.
9. The Employee Stock Ownership Plan (ESOP) Information Statement: This is a document that details how the participant will be able to exercise their rights as an owner of stock in the company. This includes instructions on setting up an account and how to make purchases from it.
10. The Rights and Responsibilities Brochure: An overview of how employee participants can make purchases from their accounts or take additional money out if they need it for some reason (e.g., for an emergency).
11. The Transferor Agreement: If you are setting up this plan, you must have this document available for employees who want to transfer their shares into your plan. This document details the terms under which an employee can transfer his or her company stock to your ESOP.
Virtual stock options
Some companies want to give employees a chance to purchase the same number of shares at the same price as everyone else, but they do not want to bother with the paperwork for an ESOP. If you are in contact with a lawyer, you may be able to work out a stock option plan that will consolidate all, or part, of your company’s shares into an ESPP (employee stock purchase program) and give employees the opportunity to buy stock through a payroll deduction. In this kind of plan, instead of buying company stock directly from the company or through a brokerage account as in an actual ESOP, participants choose how much money they want deducted from each paycheck and put into their self-directed 401(k) account. Remember, though, that such plans are only for the most select employees—for example, executives and other top-level managers.
