ESOP Rules and Regulations 101

August 23, 2022

Employee Stock Ownership Plans (ESOPs) are an attractive solution for business owners and companies that want to reward their employees for their contributions to the business. They are also an effective solution for business owners who want to retire, transition out of the business, or create a succession plan. Finally, the tax advantages and corporate financing capabilities offered by an ESOP provide unique advantages to a business.These plans are so popular that there are over 6,400 companies in the U.S. that have established an ESOP with the plans covering nearly 14 million participants. However, as with any retirement plan, ESOPs are subject to certain rules and regulations. In this post, we take a brief look at some of the most basic ESOP rules and regulations.

Why are there ESOP Rules?

The primary reason for ESOP rules is to protect plan participants. ESOPs are qualified defined contribution retirement plans wherein all contributions are made by the employer to benefit the employees; employees do not make any contributions themselves. Contributions may be in cash, in company stock shares, or both. ESOP rules and regulations are established under the Employee Retirement Income Security Act (ERISA) of the Department of Labor and the IRS’ Internal Revenue Code section 404(a)(3). These rules and guidelines ensure that all employees are treated fairly throughout their participation in the plan and are compensated appropriately when the time comes to retire and/or receive their distributions.IRS resources on ESOPs can be found here. ERISA and DOL resources can be found here.

ESOP Rules for Employee Eligibility

ESOPs are extraordinarily inclusive due to the IRS’ nondiscrimination guidelines. Rules of eligibility require that at least 70% of non-highly compensated employees be included in the plan if they are over 21 years of age and have completed one year of service with the company. Given these broad and inclusive guidelines, almost all ESOP employees are able to participate and benefit from these unique retirement plans. It should be noted that employers can choose to create a plan that opens up employee eligibility even more, such as by lowering the participation age or allowing employees to participate in the plan even before their first year of service has been completed. Conversely, stricter eligibility requirements may also be adopted but this increases the risk of violating the IRS nondiscrimination guidelines.

ESOP Rules for Participant Allocations

Employing ESOP companies make participant allocations based on the employees’ salary and/or tenure with the company. Higher earners or employees who have been the company longer tend to receive more shares or higher contribution amounts. ESOP rules set a limit of 25% of salary as the maximum amount that can be contributed to a participant’s account annually, though most companies contribute between 6-10% of salary annually. The 25% is a combined limit that includes ESOPs, 401(k)s, profit sharing, and stock bonus plans offered by the company.ESOP rules also dictate the amount of annual compensation that counts as eligible pay for participation in the plan. This number is subject to COLA (cost of living adjustments) every year. In 2022, the number is capped at $305,000.

Leveraged ESOPs Rules

Leveraged ESOPs buy shares from the sponsor company and repay them over time. As the shares are repaid, they are distributed to employee accounts. Leveraged ESOPs that are not S-Corps receive tax deductions that are limited to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years. After that time the limit decreases to 30% of EBIT (not EBITDA). In addition to the tax deduction limits, leveraged ESOPs must follow stringent rules to ensure the loan is repaid on time and that distributions to plan participants are made.

ESOP Trustee Rules

Under the Employee Retirement Income Security Act of 1974 (ERISA), ESOP trustees are the owner of record for shares held by the plan. As the owner of record, ESOP trustees are fiduciaries and are charged with protecting the retirement benefits rights of plan participants. ESOP trustees must adhere to the fiduciary requirements of ERISA and act with prudence, care, and loyalty to ESOP participants at all times. Trustees cannot insert themselves into the day-to-day operations of the business but must ensure that corporate actions are in the best interests of the employee participants.

ESOP Valuation Rules

ESOP valuations are a crucial part of an ESOP. An independent appraiser is required to value the stock annually to determine the stock’s fair market value. Appraisals must also be completed if the ESOP purchases company stock from the company or an employee, officer, director, or 10 percent or greater shareholder. The ESOP trustee or fiduciary has ultimate responsibility for valuing the stock and is responsible for selecting the appraiser and monitoring their performance. ESOP shares cannot be bought or sold for more or less than fair market value.

ESOP Rules for Plan Termination

The ESOP rules and regulations regarding plan termination are clear. Plan participants are 100% vested upon termination of the ESOP. The accounts must be distributed within a reasonable timeframe. Distributions can be rolled into an IRA for continued tax deferral benefits. Distributions that are not rolled over into another qualified retirement plan are subject to taxes but may be eligible for special tax treatment. To learn more about ESOP Distributions, read our blog post, What is An ESOP Distribution?.

Learn more about ESOPs

There are many intricacies to ESOP rules and regulations that are best discussed with an ESOP attorney for a clearer picture of how an ESOP will affect your company. If you are in need of ESOP consultation, contact Aegis Trust Company. We assist companies with ESOP Transactions, provide Ongoing Trustee Services, and offer Company ESOP Consulting. Contact us to get started.

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