ESOP Distribution Options: Exploring Strategies for Employee Stock Ownership Plan Payouts

Companies that offer Employee Stock Ownership Plans (ESOPs) are attractive to prospective employees (and do a great job retaining current team members) because of the sense of ownership that staff members feel. When responsibility is shared, and every success is collective, the results are tangible. 

One way that employees enjoy the benefits of being part of an ESOP is through the ESOP distribution, which happens when they leave the company. This disbursement of retirement benefits, as accumulated in the employee’s ESOP account, happens upon the team member’s retirement, resignation, death, disability, or termination. You can learn more about different scenarios in this helpful article.

ESOP disbursements are typically generated through shares of company stock, cash, or both. 

What are the Rules for ESOP Payout Distributions?

Every ESOP has its own carefully created plan document and distribution policy. These documents prescribe: 

• The timing of ESOP payouts
• The form of ESOP payouts  
• The method of ESOP payout
• Rules regarding a vesting schedule

Therefore, the rules are going to depend on what is laid out in the documents. However, because all ESOPs are regulated by ERISA and must comply with IRS and Department of Labor regulations, there are still rules that companies must follow before issuing an ESOP payout distribution. 

Here is a general overview of how these rules are structured, from the National Center for Employee Ownership: 

“Many ESOP participants leave with an account that has both stock and cash in it. The cash will be paid out in cash. The share portion may be cashed in, so [the participant] will get cash for the shares as well. The company might also choose to give [the participant] the shares, which [he or she will] then have 60 days to sell back to the company at the appraised fair market value. If [the participant thinks] the value will go up, [he or she] can wait one year and have another 60-day period (but there is no further right to sell after this). The payment may be in a lump sum… or in installments.”

If the payout distribution happens in installments, the value of the stock will likely change from year to year. This will result in the payout amount increasing or decreasing, depending on the stock's value in the year it was distributed.

Are ESOP Distributions Taxable?

ESOP distributions are generally taxed as regular income, at the time of distribution. A benefiting employee’s tax obligation is dependent on their age and financial situation.

In general, ESOP distributions are taxed as regular income, but if the employee is under age 59½, this will count as an early withdrawal. Early withdrawals are subject to an additional 10% tax on top of the regular income tax rate. 

To avoid these penalties, many participants choose to roll their ESOP shares into a different retirement account like a traditional IRA or a Roth conversion.

If the ESOP recipient’s distribution takes the form of a lump-sum distribution in shares, it will be taxed as regular income. The individual has to pay capital gains tax on the appreciation in share value at the time of selling the shares. 

Are There Penalties for ESOP Distributions?

Penalties may occur for ESOP participants who are past retirement age. ESOP participants who continue to work past age 70½ are required to take the minimum required distributions (RMDs), even if they are still working. If they fail to take these RMDs, they face a 50% tax penalty on the amount not taken.

For this reason, many ESOP participants choose to roll their distributions into a traditional IRA, Roth conversion, or another qualified retirement plan to defer taxation until they withdraw the funds. When the funds are withdrawn, they are typically taxed as regular income. 

ESOP Recipients typically have 60 days to complete the ESOP rollover into an IRA.

Creating More Equitable Communities

ESOPs help create more equitable and prosperous communities by spreading out the financial success of the organization. Of course, there are rules governing the exact payout distributions as well as potential penalties, which are laid out in the ESOP plan documents. 

At Aegis, we are a leading provider of ESOP Trustee services. While we don’t provide payout distributions and do not work directly with ESOP participants, we can help guide the process by working at the organizational level. If you are an ESOP participant and have questions, please reach out to your plan administrator for advice or information.