Laws on ESOP Payouts

An employee stock ownership plan (ESOP) is an investment vehicle designed to promote employee loyalty and align company staff toward a single goal: the profitability of the company. ESOPs give management and employees most of the ownership over the company in the form of stock shares. Those shares are usually paid out to employees upon retirement, but the law does allow for other distribution scenarios.

A vesting schedule is the amount of time required for the employee to be employed by a company before she can receive stock options from the company ESOP. By law, ESOPs are required to follow one of two basic vesting schedules:

Cliff Vesting: Employees are entitled to 100 percent ESOP participation no later than the completion of three years of employment Graded Vesting: Employees are entitled to 20 percent participation after the second year of employment, and an additional 20 percent per year for the next four years, totaling 100 percent vesting after six years

Employees who do not meet the minimum vesting requirements before leaving the company forfeit ESOP participation and, as a result, any ESOP payouts to which they would have been entitled.

By law, ESOPs are required to begin paying benefits to ESOP participants during the plan year following the year in which the employee retires (or dies or is disabled.) After that, the employee's ESOP benefits must be paid at least annually and be completely distributed to the employee no later than five years after the first payment has been made. However, if the employee's entitlement is worth more than a certain amount ($985,000 in 2010) the ESOP payout may be extended one additional year for each $170,000 by which the entitlement exceeds that cap.

When an employee leaves a company without retiring, dying or becoming disabled, ESOP payouts are permitted to wait until after the sixth plan year after the year in which the employee left the company. If, however, the ESOP itself was created before 1987, ESOP payouts do not have to begin until the employee reaches retirement age.

ESOP payouts can be distributed to participants in four main ways:

Diversification: Employees over the age of 55 who have participated in an ESOP for more than 10 years are allowed to diversify their ESOP share by up to 25 percent over five years, and up to a total of 50 percent until the close of the sixth year. This means employees can trade in part of their ESOP shares for outside retirement programs or other securities, which can then be converted to cash if applicable.

Dividends: Some ESOPs pay dividends ("bonus" payouts based on company earnings and participant share ownership) to existing ESOP participants, but this is not required by law.

Share and Age Minimums: All employees over age 70 1/2 who own at least 5 percent of the company through its ESOP are entitled by law to begin receiving ESOP payout distributions.

Other Circumstances: The ESOP may allow for early payouts based on years of service, minimum age or hardship, but this is not required by law.

No ESOP participant is required to pay any taxes on employee ownership shares until the shares are cashed out, at which point ESOP payouts are taxed as regular income. If the payout is distributed and cashed out while the ESOP participant is still employed, an additional excise tax of 10 percent is levied.

Dividends, if the company does pay any, are taxed as regular income, but they are not subject to tax withholding or excise taxes.

A put option is the right, but not the obligation, to sell a stock to someone. In the case of ESOPs, it is the right of the ESOP participant (employee) to sell her share of stock to the company at fair market value. In the case of closely held companies (at least 85 percent of the stock is held by management and employees) fair market value is assessed by an objective third-party annually. The put option can be exercised by an ESOP participant during one of two periods: the 60 days following distribution or a 60-day period in the following plan year.