Employee Benefit Plans: The 411

Valuable Information on 401ks, Pensions, ESOPs, Form 5500 Preparation + More

What is an ESOP?

I started a new job as an accounting manager and my employer notified me that I will be eligible to participate in their Employee Stock Ownership Plan (“ESOP”) after one year of service. They also said the ESOP was leveraged. In addition to being eligible to participate in the ESOP, I was given the task of accounting for the ESOP. On a high level, what is an ESOP and what does it mean to be leveraged?

Answer: An ESOP is a tax qualified defined contribution benefit plan. Unlike 401(k) plans and defined benefit plans, an ESOP’s main investment is primarily in the stock of the employer/sponsoring company.

Generally, a company establishes a trust to which the employer contributes stock or cash to purchase stock.  The stock is then allocated out to employees’ individual accounts within the trust.  When cash is contributed it is used to purchase stock from shareholders and then allocated out to individual employee accounts. A leveraged ESOP works as follows:

  1. Lender lends Company/Employer cash via a note.
  2. The Company then turns around and lends cash to the ESOP Trust via a note.
  3. The ESOP Trust buys stock from current shareholders of the Employer.
  4. The Employer makes annual tax-deductible contributions to the ESOP Trust.
  5. The ESOP Trust then turns around (with the contribution used in D) and pays the cash due on the Note to the Employer, and the Employer uses this cash to pay the Note to the Lender.
  6. After the Employer makes contributions to the ESOP Trust (letter D), the ESOP Trust will allocate shares to eligible employees’ individual accounts. The allocation is based on eligible employee compensation. The ESOP maintains the records for the individuals’ accounts, and annually will notify them of how much stock they own, and the fair value of that stock as of the valuation date. When the employee leaves or retires from the company, (and depending on their vesting percentage), the employee will receive stock or cash, but generally will receive a cash distribution.

In general a non – leveraged ESOP works as follows:

  1. The Company/Employer sets up an ESOP Trust.
  2. The Employer makes annual tax-deductible contributions to the  ESOP Trust.
  3. The ESOP Trust buys stock from current shareholders of the Employer.
  4. The recently purchased stock is allocated to eligible employees’ individual accounts. The allocation is based on eligible employee compensation. The ESOP maintains the records for the individuals’ accounts, and annually will notify them of how much stock they own, and the fair value of that stock as of the valuation date. When the employee leaves or retires from the company, (and depending on their vesting percentage), the employee will receive stock or cash, but generally will receive a cash distribution.

There are many accounting issues that need to be considered when accounting for ESOP transactions.  Your ESOP may also be subject to an audit requirement.  Please contact us if you have any questions on the accounting requirements specific to an ESOP, or the audit requirements for an ESOP. 

Victor Fuentes