The initiation of an Employee Stock Ownership Plan or ESOP is a major investment, and one that can pay dividends for you and your employees for years to come. However, there are many intricacies to an ESOP that can be overlooked. Proper education of the potential impacts of an ESOP is essential for both you and your employees to reap the full investment.
An ESOP is an ERISA qualified plan that implements an employee stock ownership program. After being set up by the employer, a trust is established, to which the employer then makes tax-deductible contributions, with the goal of eventually distributing those to employees in the form of stock. This allows employees to reap the benefits of being a part of the company, bringing a new level of corporate culture to the workplace. However, failing to properly understand the various intricacies of an ESOP can mean major issues for both you and your employees. One of the most important considerations is the rules surrounding what is called diversification.
If you haven’t properly explained the rules surrounding diversification to your participating employees, they could find themselves paying extra taxes unnecessarily or losing out on major earnings. The Department of Labor requires companies to simplify complex ESOP information for participating employees, but this is generally not done. This complexity can be particularly troublesome for those employees who spend most of their work hours in flameproof and explosion-proof environments, where it’s essential to prevent potential accidents. They’re not expecting to get into the nitty-gritty details of their company’s ESOP, and as such, they need the information to be clearly organized and presented to them.
Because the taxation and distribution process varies based on circumstances, employees should be advised to consult their own tax advisors prior to making any decisions. However, a general overview of ESOP diversification can be quite beneficial as well.
For ESOP participants younger than 55 years of age or those who have less than 10 years of participation in the plan, they are limited to 25% of their vested account balance at the time of diversification elections. For those over 55 years of age or those who have participated in the plan for at least 10 years, employees are allowed to diversify their full vested account balance at the time of diversification elections. Employees should be particularly encouraged to take advantage of diversifying their stock holdings for sound tax-planning purposes, as they may not be able to when it comes time for distributions upon retirement.
One of the major reasons the ESOP rules require employees to be educated on diversification is that it offers them major financial advantages. When employees are fully vested in their ESOP accounts, they may be able to access the value from their account at a lower tax rate than they would otherwise pay if they received the value as compensation. This can be a significant financial advantage for those who want to take advantage of their hard work with solid long-term investments.
At the same time, equally important is that employees have the opportunity to diversify their vested accounts to limit their risk of loss, both individually and as a company. For example, if the price of stock drops, having the freedom to diversify one’s holdings to other asset classes protects employees from total loss. Additionally, diversifying through investing instead of accumulating cash outside of their tax-advantaged compensation plan can save employees thousands in taxes-especially for those who are nearing retirement age.
That being said, not all employees take advantage of their rights to diversify their ESOPs. Without a good understanding the ins and outs of the ESOP diversification rules, they may end up with a lot of eggs in one basket without enough to show for it when they reach retirement age.
Understanding the ins and outs of diversification is crucial to being an effective company leader with an ESOP. Saving money and protecting their interests through proper diversifications can bring major rewards to your employees. Considering that the ESOP contribution is being made by your company, it’s only right that they get the most out of it that they can.
The good news for employers is that employees don’t have to be experts in diversification, but rather the plan must address the complexity. Because ESOPs have many moving parts that link to many different laws, it’s vital that you enlist the assistance of a knowledgeable ESOP lawyer to ensure that you understand the nuances of implementing an ESOP in a way that’s safe for you and your employees.
