Employee Stock Ownership Plans (ESOP): Let's take a look

Employee Stock Ownership Plans (ESOP): Let's take a look

November 01, 2021

Summary: This article presents a foundational look at Employee Stock Ownership Plans (ESOPs).  Whether you’re an employee who has (or will have) access to an ESOP, or you’re an employer who’s considering a new ESOP offering for your employees, this article will present a broad look at some of the factors to consider.

For most, the normal lexicon of retirement plans usually spans as far as 401(k)’s, IRAs, Roths – the usual suspects.  As you devote yourself to your career and become more successful, opportunities to participate in the lesser-known retirement plans start to emerge: ESOP’s, profit-sharing plans, ISO’s, RSU’s, and the rest of the retirement plan alphabet soup.  These are benefits that employers may offer higher paid employees and executives.  If you’re starting to receive these benefit offerings it’s because you’ve undoubtedly grown in your career through all of your hard work, which means you may not have had time to read up on the nuances of these different employee benefits.   

Employee Stock Ownership Plans (ESOPs) will be the focus for this article.  The rules for ESOPs can get complicated so check in with your CFP® and your CPA to make sure you consider every complex angle as it relates to your personal situation.  In the meantime, let’s take a look at the basis of ESOPs with the hope that you’ll walk away with a fundamental understanding of what they do and why they might be worth considering for your own retirement planning. 

So, what’s an ESOP?  It’s type of retirement plan that a company might offer to their higher paid employees and executives.  It’s generally offered as a means of giving certain employees ownership in the company.  ESOPs are considered tax-qualified plans because of the unique tax benefits they offer.  Basically, they’re set up as a trust and then funded with company stock (or cash, which is then used to buy the company stock).  Ultimately, ESOPs are primarily meant to hold company stock (not in option form, rather, in true equity ownership form).  

Why would a company want to do this?  By awarding shares of stock to the ESOP participants, the benefit program can act as a great motivator.  Think about it, with ownership comes pride of ownership.  When a company shares success and responsibility, the motivations of an employee become more aligned with the motivations of an employer.  This is because they’re both rowing in the same direction now, all towards a common goal: company stock price appreciation (one of many common goals).  Giving an employee a little skin in the game can translate into a ton of value for everyone. 

Another advantage that’s afforded to the employer is the flexibility to fund retirement plans with stock rather than cash. A business with fluctuating or unpredictable cash flow may have a hard time making regular contributions to a retirement plan.  ESOPs allow the company to fund the plan with company stock, which can be a bottom-line saver in a year when cash flow is in a lull. 

What about the employer’s bottom line?  It’s all about the taxes.  Employers can generally deduct the contributions made to an ESOP up to 25% of covered payroll (includes contributions made to other defined contribution plans).  This is a significant benefit for the employer because there’s no cash outlay – just a contribution of stock.  The employee does not have to pay income taxes on contributions made to an ESOP – a useful tool for managing your tax bracket.  Instead, they’re taxed upon distribution, but typically at very favorable rates (this tax concept is called NUA).  

What is NUA?  Should you care about NUA?  Yes. Yes. Yes.  There’s a very attractive tax benefit offered by way of NUA (Net Unrealized Appreciation).  A CFP® and a CPA should be consulted before selecting how you want to distribute your ESOP.  NUA gives an employee the option to take a taxable distribution (must distribute the entire account within a year), but at a preferential tax rate (long-term capital gains).  There are nuances to the NUA rule and the steps you must take to capitalize on it, but it may be an effective tax saving strategy and worth the effort that it takes to learn about it.  Here’s a quick overview:

When you distribute the stock within the ESOP and identify it as an NUA distribution, you’re only taxed on the cost basis of the stock (which is great if you’re holding highly appreciated stock).  The value of the stock above the basis (aka NUA) is taxed at the long-term capital gains rate (which is far more favorable than the ordinary income rate that you’d be taxed at if you took a normal distribution) when you sell the stock at some point in the future.  You could actually sell the day you transfer the stock and you’d still get the benefit of being taxed at a long term capital gains rate – a huge benefit!  If you decide to hold on to it and sell later, any additional gain will be taxed at a short- or long-term capital gains rate depending on how long you hold the stock.  Be sure to keep in mind that you’re still potentially subject to the 10% early withdrawal penalty.  

What’s the bottom line?  If you’re an employee considering participating in, or an employer considering offering an ESOP, it’ll be best to run your individual circumstances by your CPA and CFP®.  With that said, the NUA tax benefit can be a huge value add if the circumstances are right.  They offer a great way for an employer to fund retirement plans without the outlay of cash, AND they get a tax deduction for it. But Be Warry! Taking advantage of the NUA tax benefit isn’t always the best way to go, and many people leverage it inappropriately because they think it’s automatically the best route.  Run scenarios and do the numbers before you make any decisions. 

If you have any questions about the mechanics of an ESOP or you’d like to get more granular, please feel free to reach out to us with your questions.  We’re always here and always happy to talk.


Scott Stanley, CFP®

Founder of Pharos Wealth Management 


There are some other great resources out there that'll give you a more in depth look at the nuances of NUA.  Kitces.com shares the best, most detailed explanation here: https://www.kitces.com/blog/net-unrealized-appreciation-nua-tax-reduction-capital-gains-short-term-early-retirment-funding/

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