ESOP Distribution Rules and Guidelines
ESOP (Employee Stock Options Plan) has been serving as a perfect retirement plan for participants across the globe in recent years. Since this can be an essential source of employee savings, the participants must have a comprehensive knowledge of the plan and leverage its generous benefits. Also, safe distribution practices and policies can help the active participants, as well as the employers, reap its benefits. This article can guide you to understand ESOP distribution better and lists the rules and guidelines one should follow while practicing distribution.
What is ESOP distribution?
ESOP distribution is the practice of returning the payout benefits to the employees who have been active participants throughout a specific period as required by the company. The participants must fall under one of the following categories to qualify for an ESOP distribution. They must
- Be over 59 years of age and have retired from the services.
- Be over 55 years of age and terminated from the company or quit.
- Be over 70 years of age and still working within the organization.
The distributions can be made in installments or lump sum in a specific period but not exceeding five years.
How does ESOP distribution work?
IRS (Internal Revenue Service) governs the formulations of ESOP distributions according to the guidelines set by an individual company. Every company must have a well-defined ESOP distribution policy as a document. This record will have details of the vesting schedules, distribution methods (lump sum or installments), and payout options. Companies choose their mode of distribution by referring to these policies. Similarly, companies can offer distribution forms only if the employee participants have vested according to the schedules mentioned. Distributions are made not just in the form of stocks but also cash. These regulations are subject to annual adjustments.
Distribution when the company is sold
When a company is acquired or sold, what happens to your ESOP distribution entirely depends on the types of stocks and the vesting schedule. Vested stock options of an acquired company can be received by liquidating the concerned employee’s position. The current strike price and new share price will determine the amount he receives. In some instances where the stocks are underwater (i.e., the present market value has decreased below the strike price), the new employers may offer a fee in return for invalidating the grants.
Distribution when the employee leaves
When an employee leaves the company for reasons other than disability, death, or retirement, his ESOP distribution will be on hold until five years after the termination. After this, he may start receiving payments from the sixth year. It is important to note that by this time, the balance in the employee’s ESOP would have exceeded the cash-out options.
Distribution when ESOP is leveraged
Certain companies might have borrowed funds from the ESOP trust to buy more company shares. In such cases, the company has to wait until the debts are entirely cleared. Distributions can happen from the following year.
Distribution when employment is terminated
When the employment is terminated for death, disability, and retirement, ESOPs should be distributed from the same year as the retirement or onset of disability and death. This can be made in either a lump sum or installments within five years of the plan.
Forms of ESOP Distribution
As mentioned earlier, the ESOP distribution can take any form depending on the individual company policy and the termination mode. Documents containing distribution policies would often suggest cash or stock distributions. Here are a few common distribution forms for your reference.
Stock Distribution
When the companies are not subject to restrictive laws regarding employer securities, the distributions are primarily made in stocks. The participant can exercise his right to demand payments in the form of stocks if his stocks in the ESOP account are not publicly traded.
Put Option
According to section 409h, the put option allows the employee participants to sell the received stocks at the present fair market value to the company. The put options can be availed either 60 days right after the distribution or 60 days in the following year when the plan is effective.
Cash Distribution
When the companies do not want to pay back distribution in the form of stocks, they can pay in cash. According to the funds in the ESOP trust, they can add new money, pay dividends or redeem the old shares to proceed with the distribution.
ESOP Reshuffling
Sometimes the employers may buy a few or all of the shares of the employees who are currently terminated from the company. Their cash is secured in other forms of distribution until they plan to distribute. This allows the former workers to avoid future losses or gains through the ESOP stocks. This is called ESOP reshuffling.
Taxation on ESOP Distribution
Employees will be taxed once they receive ESOP distributions. If an employee under 59.5 years of age withdraws earlier, they can be expected to pay regular taxes with a 10% excise tax. If the withdrawal is due to death or disability, the excise tax can be exempted. Similarly, if the distributions are made directly to the ESOP participants, they will be exempted from excise and income tax withholding.
Summing up
Due to the extensive rules and guidelines, employees may need help understanding how ESOP distributions work. This is why companies must communicate transparently with employees regarding distribution policies and taxation in advance. At Eqvista, we offer consultations and proven strategies to frame your ESOP policies with complete adherence to laws. If you have any queries, please book a consultation call with us.
