How Are Shares Allocated in an ESOP?

Employee Stock Ownership Plans (ESOPs) are qualified retirement plans that grant company shares of stock to employee participants. One common question that owners and ESOP sponsors must address early in the ESOP's formation is how the shares will be allocated to participants.

Let's explore the key factors that determine share allocation and the requirements that help ensure fair distribution among eligible employees.

What Is an ESOP and How Do ESOP Share Allocations Work?

How are ESOP shares allocated? When an ESOP is established, a trust fund is created to hold company shares for eligible employees. This trust can receive newly issued shares or use cash to purchase existing shares. Each year, shares of company stock are allocated to individual participants' ESOP retirement accounts according to the plan's allocation formula.

Generally, ESOPs are open to full-time employees aged 21 and over who have completed one year of service. However, plans may modify these requirements. Some allow younger employees to participate or offer earlier enrollment. The specific eligibility requirements must be clearly outlined in the plan document.

When participants leave the company or retire, they can request a distribution from their account if they meet vesting requirements. These distributions are cash payments based on the fair market value of the vested shares in the participant's account at the time of distribution. 

How Does The ESOP Ensure Allocations Are Fair?

ESOPs must comply with strict regulations from the IRS, the Department of Labor, and ERISA to ensure fair and non-discriminatory share allocations among participants. Your company’s independent trustee acts as fiduciary to ensure compliance with plan documents and regulatory requirements, including overseeing share valuation.

How Does an ESOP Ensure Fair Share Allocation?

Most ESOPs allocate shares in proportion to employee compensation, meaning higher-paid employees receive more shares than lower-paid employees. However, the IRS has established minimum coverage requirements to prevent disproportionate benefits to highly compensated employees (HCEs). Specifically, the percentage of non-highly compensated employees covered by the ESOP must be at least 70% of the percentage of HCEs benefiting from the plan. Additionally, the plan must demonstrate that allocations do not discriminate in favor of HCEs.

Some allocation formulas may also consider employee tenure. While longer-serving employees naturally accumulate more shares over time through continued participation, some plans explicitly factor in length of service when determining annual allocations.

The Issuance ESOP: Understanding Share Distribution Methods

An issuance ESOP is a type of ESOP transaction where the sponsoring company issues new shares directly to the ESOP trust. This process can be structured as either a leveraged or non-leveraged transaction, each with distinct characteristics.

In a leveraged transaction, the ESOP obtains financing from a bank or lender to purchase shares from current shareholders. As the loan is paid down over time, shares are gradually allocated to employee accounts in proportion to the loan repayment.

Non-leveraged transactions occur without external financing. Instead, the company or owner contributes shares directly to the plan, which are then allocated to employee accounts through the trust according to the plan's allocation formula.

Factors That Affect ESOP Allocations

Several key factors determine how ESOP shares are allocated and the number of shares each employee receives. These include: 

Available Shares

Allocations depend on the number of shares available in the trust at allocation time. The trust can only allocate shares it owns and has paid for. As companies grow, more shares may become available as the company's value increases.

Leveraged Share Release

In leveraged ESOPs, shares become available for allocation as debt is repaid. Initially, these purchased shares are recorded as “unearned ESOP shares” in a contra-equity account on the balance sheet until they're released from collateral through loan payments. This gradual release process may affect the number of shares available for annual allocation. 

‍Allocation Formula

Share distribution depends on the ESOP plan's established formula. Most ESOPs allocate shares in proportion to employee compensation, while some also factor in length of service.

Vesting Schedule

The vesting schedule determines when participants gain access to the assets in their ESOP accounts. Plans may offer immediate vesting, cliff vesting after a set period, or gradual vesting over time. Plan documents specify distribution methods upon retirement or resignation.

Maximum Compensation Limits

The IRS sets annual limits on ESOP allocations based on participant compensation. These limits are adjusted annually for inflation, and earnings above the current year's threshold are not considered for additional allocations.

When Do ESOP Participants Receive Distributions?

ESOP distribution timing depends on several key factors outlined in the plan document. Generally, participants become eligible for distributions upon retirement, disability, death, or termination of employment, provided they have met the plan's vesting requirements.

The specific distribution schedule varies by plan, but most ESOPs begin distributions no later than one year after the close of the plan year in which the participant retires or terminates employment. For participants who leave before retirement age, the plan may delay distribution up to six years after separation.

Distribution methods can vary, with some plans offering lump-sum payments while others provide installment payments over several years. The plan document will specify whether distributions are made in cash, company stock, or a combination of both. It's important to note that these distributions represent the fair market value of vested shares in the participant's account at the time of distribution.

Required ESOP Disclosures to Plan Participants

ESOPs are subject to strict regulatory oversight, requiring IRS approval of the plan design and fiduciary management. These requirements help protect participants and optimize plan benefits. 

The following disclosures must be provided to plan participants:

• Summary Plan Description (SPD): Participants must receive this document outlining ESOP rules, including share allocation methods, vesting schedules, and distribution procedures.
• Summary Annual Report: Within seven months of the plan's fiscal year-end, participants must receive this Department of Labor Form 5500 report detailing plan activity and assets.
• Individual Benefit Statements: Participants must receive these statements annually, upon termination, upon request, or after a one-year break in service. Statements show the fair market value of shares and vesting status.
• Access to Plan Documents: Participants must have access to the plan document, trust documents, annual plan report, and summary plan description.
• Shareholder Rights Information: As shareholders, ESOP participants have specific voting rights regarding share allocation, company stock sales, mergers and acquisitions, and other major corporate actions. These rights must be clearly communicated.

It's important to note that while these disclosures are required, ESOPs are not obligated to share company financial statements, salary information, or share ownership structure with plan participants.

ESOP Trustee Services at Aegis Trust Company

As experienced ESOP trustees, Aegis Trust Company specializes in providing comprehensive trustee services to privately held companies that sponsor employee stock ownership plans. We deeply understand the complexities of ESOP formation, transaction oversight, and ongoing administration.

Our team offers expert guidance throughout your ESOP journey, whether you're exploring employee ownership options, requiring transaction trustee services, or seeking ongoing trustee support. With our deep understanding of ESOP regulations and commitment to protecting participant interests, we help ensure your plan operates effectively and compliantly.

Contact Aegis Trust Company today to discuss how our services can support your company's employee ownership goals!