ESOP vs ESPP - What's the Difference?

September 16, 2022

Employee stock ownership plans (ESOPs) and employee stock purchase plans (ESPPs) are both attractive employee benefits that help participants save for retirement and build wealth. They each encourage employee investment in the business in both a literal and figurative sense, which can aid in retention efforts while boosting employee satisfaction and productivity. Many business owners find themselves questioning ESOP vs ESPP.Despite their similarities, ESOPs and ESPPs have important differences. The most significant difference is that an ESOP is a qualified defined contribution retirement plan in which shares are provided to employees by their employer at no cost to the employee. ESPPs require the employee to purchase shares, but those shares are available at a discounted price. Below, we compare and contrast ESOP vs ESPP and explore the pros and cons of each type of plan.

What is an ESOP or Employee Stock Ownership Plan?

ESOPs are an employee benefit that makes employees part owner of the company they work for by providing them with shares of stock. They are often used as a succession planning tool for business owners and as a unique and valuable employee benefit. ESOPs can be highly motivating to employees because they receive direct financial benefits based on the company’s success.There are many benefits of an ESOP for both employees and employers. Some of the biggest pros of an ESOP are:

  • Ownership control. An ESOP is a smart succession planning tool for owners who want to retire or gradually transition from day-to-day management of the business but aren’t quite ready to cut ties entirely.
  • Business Continuation. Forming an ESOP means the business stays in its current form. Owners do not have to worry that the business will be absorbed or dissolved as it might under a sale to a third party.
  • A Ready Market for Stock. Owners who want to transition have a ready market to sell their shares in an ESOP…to their employees.
  • Financial Benefits for Employees. Employees receive shares as a free benefit to them. They do not have to invest any of their own funds to acquire shares which makes the retirement plan more accessible to all employees. As the business grows in value, so do the employees’ retirement accounts.
  • Work Culture and Work Satisfaction Benefits. Employees gain the benefit of being an owner of their company. This can boost morale and worker satisfaction, increase pride in the business, and motivate employees to work harder so the business continues to grow and flourish.
  • Tax Advantages. The business can deduct the principal amount of the ESOP from its taxes. Recognized earnings from the ESOP are exempt from income taxes for S-Corps. Plan participants are not taxed on their ESOP benefits until they receive their distribution at retirement.
  • Source of liquid capital. An ESOP converts shares into capital that business owners can use to reinvest in the business.

Just as there are pros, there are cons to an ESOP. These include:

  • Share Prices are Limited to Fair Market Value (FMV). ESOP shares can never be sold for more than FMV. This makes it impossible to meet the price premium that a strategic buyer may pay for the business.
  • Ongoing Costs. Like any retirement plan or stock management plan, an ESOP must be managed and maintained. These annual administrative costs and fees must be considered when setting up an ESOP.
  • May be Less Attractive to Investors. It can be difficult to find outside lenders who are willing to loan money to or invest in a company that is 100% employee-owned.
  • Complicated Regulatory Requirements. ESOPs are governed by ERISA and must meet federal DOL and IRS requirements. Professional administration is a must to ensure absolute compliance with these ESOP rules and regulations.

What is an ESPP or Employee Stock Purchase Plan?

ESPPs are company-run programs that allow employees to buy company stock at a discounted price through after-tax payroll deductions. The discounted rate is set by the company. The payroll deductions build-up between the purchase date and the offering date. When the day of purchase arrives, the company buys stock for the participants by using the accumulated funds. There are two types of ESPPs: qualified and non-qualified plans. Qualified plans require shareholder approval before implementation and all participants have equal rights in the plan. The offering period of these plans can be no more than 3 years and there are restrictions on the maximum price discounted allowed. Non-qualified plans do not have these same restrictions, but they also lack the after-tax deduction benefits of qualified plans. The pros of ESPPs indicate similar benefits to employees as an ESOP. These include:

  • Increases Morale and Retention. Employees who have an opportunity to invest in their employer have more “skin in the game”. They tend to want to do their best to help the company achieve success so that they can reap the financial rewards. There is a sense of pride in the workplace that does not exist when employees are not shareholders as well.
  • Aligns Shareholder and Employee Interests. ESPPs put shareholders and employees on the same page instead of pitting them against one another, which frequently happens in publicly traded companies. They both benefit financially from the continued success of the business and both now pay attention to the mission and future direction of the company.
  • Wealth Building Gains for Employees. Allowing employees to purchase stock at a discounted price can provide them with significant financial gains, particularly if the stock increases in value from the time they first start contributing to the plan to the time they are able to make the purchase.
  • Shares Can be Sold at Any Time. ESPP shares can be sold at any time, not just upon retirement. If stock value increases dramatically during the time that an employee owns the stock, they can realize large financial gains by choosing to sell at a high point.
  • Vesting Periods Help With Retention. Vesting periods of ESPPs help retain workers who don’t want to lose those benefits. Top performers are more likely to stay and to continue to work hard towards the business mission in order to increase share value and maximize their investment.

There are disadvantages of an ESPP that we want to cover as well. These include:

  • Share Prices Can be Volatile. Just as shares can go up, they can also go down. If the share prices decrease below the price at which the stock was purchased, employees can take a loss.
  • There May be a Holding Period. Some ESPPs require the stock to be held for a certain amount of time before it can be sold. If the price decreases during this holding period, employees may lose out on selling at a high price.
  • Administrative Costs. ESPPs are administered by the company which can lead to increased administrative, accounting, and HR work and/or additional costs, particularly if outside administrators are hired to manage the plan.
  • Requires Belief in the Future and Mission of the Company. Employees have to believe that the business will succeed and shares will increase in price to be encouraged to participate.
  • Tax Implications. Sales of ESPP stock immediately upon receipt are subject to the standard income tax rate of 15% of the amount of the shares based on the discount they received. They also must pay short-term capital gains on their profits.
  • Regulatory Issues. An ESPP is a stock option plan and must be compliant with many rules and regulations including securities and tax laws.

ESOP vs ESPP - The Difference

The most notable difference between an ESOP vs ESPP is in how the employee receives the stock and when they can sell the stock.ESOPs provide the stock or shares at no cost to employees. ESPPs require participants to contribute funds to purchase shares of stock, though at a discounted rate.ESOPs are qualified defined contribution retirement plans. Shares cannot be sold or distributions taken before the age of 65, even if you have left the company or retired early, and the money in the account is not taxed until the distribution is taken. Learn more about ESOP Distributions in our post, What is an ESOP Distribution? ESPPs, by contrast, are voluntary stock purchases made with after-tax dollars. They are subject to capital gains tax when sold, which can be as soon as participants meet the vesting requirements and barring a holding period.

Discover the Benefits of an ESOP & How Aegis Can Help

Is an ESOP right for your business? Or wondering about ESOP vs ESPP for you? Contact Aegis Trust Company to find out. As ESOP trustees, we can help you assess the pros and cons of ESOP formation and how they apply to your company. Reach out today to learn more.

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