How Are Shares Allocated in an ESOP?

Employee stock ownership plans (ESOP) are qualified retirement plans that grant company shares of stock to employee participants. One common question that owners and ESOP sponsors have to address early in the formation of the ESOP is how those shares will be allocated to participants.

Who Can Participate In ESOP Shares Allocation?

Anyone who participates in the ESOP will receive a shares allocation. When an ESOP is started, a trust fund is set up. The fund is comprised of newly issued shares and/or cash to purchase existing shares which, once purchased, go back into the trust. Shares of company stock are allocated to each employee participant’s individual ESOP retirement plan account every year.Most ESOPs are open to all full-time employees who are over age 21 and may have a waiting period before the employee can participate. Some plans waive these requirements and let younger employees participate in the plan or allow employees to enroll in the plan immediately. Who can participate in the ESOP and when must be disclosed in the plan document.When participants leave the company or retire, they are able to request a distribution from their account if they have met vesting requirements. ESOP distributions are cash payments based on the current fair market value of the shares in the participant’s account at the time of distribution. The former employee receives cash and the shares are sold back to the ESOP sponsor, going back into the trust fund to be reallocated to remaining participant accounts.

How Does The ESOP Ensure Allocations Are Fair?

Each individual ESOP determines who gets how many shares and how shares will be allocated fairly. Despite what you may have heard about ESOPs favoring some participants over others, they are highly regulated by the IRS, DOL, and ERISA. This helps to guarantee fairness and non-discrimination for all participants. An independent trustee acts as fiduciary to further ensure compliance with plan documents and regulatory requirements as well as determine the fair market value of the shares.One way to ensure the fair allocation of shares is to allocate shares in proportion to the employee’s annual total compensation. Higher earners earn more shares than lower earners. In order to avoid higher earners receiving a disproportionate number of shares, the IRS has set minimum coverage requirements to prevent ESOPs from disproportionately benefiting high earners.The rule states that the percentage of non-highly compensated employees in the ESOP must be at least 70% of the percentage of highly compensated employees in the ESOP. The plan must also demonstrate that allocations do not favor the higher earners.Tenure may also be taken into account in some cases with longer-serving employees earning more shares than newer employees. Naturally over time, longer tenured employees acquire more shares than newer employees simply due to the fact that they have been participating in the plan for a longer amount of time.

The Issuance ESOP

An Issuance ESOP is an ESOP transaction. During this process, the sponsoring company issues new shares to the ESOP trust. The transaction can be leveraged or non-leveraged. Leveraged transactions require financing from the bank or lender, allowing the ESOP to purchase shares from current shareholders. Shares are then allocated to employee accounts as the loan is paid down.Non-leveraged transactions do not require financing. Shares are contributed to the plan from the company/owner holdings and then allocated to employee accounts from the trust.

Factors That Affect ESOP Allocations

There are a number of factors that affect ESOP allocations and how many shares an employee receives.

• Shares Available. Allocations are based on the number of shares available at that point in time. The trust cannot allocate more shares than what is actually owned and paid for. Ideally, the business grows over time and more shares become available as the value of the company increases. A company also acquires additional shares when they buy shares back from retired or former employees who have obtained a distribution from their ESOP account. If they are not voided by the company, these shares go back into the share pool to be redistributed among the remaining plan participants.

• Leveraged Shares. Related to the point above, if an ESOP is leveraged, shares are released to the trust for allocation as the debt is repaid. This may result in smaller numbers of shares being available for allocation than anticipated.

• The Contribution Formula. How many shares a participant receives depends on how the ESOP was set up to distribute shares. Is it based on compensation? Tenure? A combination of both? Typically, participants earn an increasing proportion of shares for each year of their service with the company.

• The Vesting Schedule. How and when shares vest determines how and when plan participants have access to the assets in their ESOP accounts. Vesting may happen immediately, after a set number of years, or gradually over time. When fully vested, an employee who retires or resigns is able to seek a distribution by selling their shares back to the company. Plan documents dictate how the funds are distributed – as a lump sum or in periodic payments.

• Maximum Compensation Limits. ESOPs do have caps on contributions. The maximum annual allocation to an individual account is dependent on that person’s annual compensation. Per IRS guidelines, the compensation limit for 2022 is $305,000. Anyone who makes more than that is ineligible to receive additional ESOP allocations.

Disclosures To Be Made By The ESOP

As mentioned above, ESOPs are highly regulated. Each ESOP must submit a plan design to the IRS for review and approval and the plan must be managed by a fiduciary. All of these steps are intended to protect plan participants and help plan sponsors maximize the benefits of the ESOP.In the plan document, certain information must be disclosed. This includes:

• Summary Plan Description (SPD). Employees must be provided with an SPD, which is where they will find the rules of the ESOP, including how shares are allocated, the vesting schedule, and how and when to seek a distribution.

• Summary Annual Report. Every year, within 7 months of the end of the plan’s fiscal year, this report must be provided on a Department of Labor 5500 form. This report contains information on plan activity and assets and must be made available to ESOP participants.

• Individual Benefit Statements. Employees must receive an annual benefit statement every year, upon termination, upon request, or after a one-year break in service. These individual reports indicate the fair market value of their ESOP shares along with vesting information.

• Access to Plan Documents. The actual plan document itself, trust documents, and annual plan report must be made available to plan participants for viewing, along with the summary plan description.

• Shareholder Voting, Proxies, and Other Voting Disclosure Material. As ESOP participants, employees become shareholders in the company. This gives them some voting rights related to the allocation of shares, sale of company stock or other assets, questions related to mergers and acquisitions and more. Those voting rights must be specified and shared with employees.

Missing from this list are company financial statements. ESOPs are not required to disclose this information, salaries, or share ownership structure to plan participants.

ESOP Trustee Services at Aegis Trust Company

Aegis Trust Company provides trustee services to privately-held companies that sponsor ESOPs. Our team is available to assist business owners with consultations on establishing an ESOP as well as offering services as transaction trustees and ongoing trustees. Learn more about our services, here or contact us to discuss your needs in detail.