Employee Stock Options: Understanding the Contract

Welcome to the first post in the “2023 Stock Compensation” section. Check back if you want to read more on stock options or grants.

Employee Stock Ownership Plans (ESOPs) are in vogue right now, as it’s a benefit that provides potentially high upside to employees for a minimal cost to the companies that offer them. If you have an ESOP at your employer, you may be wondering: “Should I contribute to this?” and “How does my ESOP work?”

The reality is that each ESOP is different. Companies write these plans as complex contracts with their own features. That said, ESOP plans have a number of standard features you can look for. You will want to understand these four things for your plan: who funds the purchase of stock, the discount given on the stock, any restrictions on stock sale, and the tax treatment of the funds. Knowing these things will help you manage the complexities of your individual pact.

Who Funds the Purchase

ESOPs are set up to encourage employees to own stock in the company, so many require the investment of your own paycheck into the company stock. Some plans will offer an additional match of employer contributions. In rare cases, the employer may offer the stock to you as an added benefit while not asking for your contribution. Understanding how funds are contributed to the ESOP is very important to evaluating whether and how much you should invest.

The Discount Given

In ESOPs where you contribute your own funds, the employer usually gives a discount of 5-20% on the purchase price of the stock. This means that you are buying more stock through the ESOP than you would receive on the open market. It also means that from the first day the purchase goes through, you have made a profit on the stock. That profit may increase or decrease over time, but it’s assured if there is a discount given and you sell.

Restrictions On Stock Sale

ESOPs often have a period of time, such as once per quarter, that the stock enters your account. There may be a period after this transaction takes place where you are unable to sell the stock. Having restrictions reduces the amount control you are guaranteed in an ESOP, as holding the stock as it is decreasing will reduce the value of your discount if one is given. This removes a potential strategy of maxing your contributions and then selling the stock for a profit as soon as it hits your account.

Tax Treatment

Often ESOP funds are after-tax, meaning that you can withdraw the profits while only recognizing taxes under capital gains rules. The portion that the employer matches or contributes without a match will often be pre-tax, meaning that the funds may behave under other retirement account rules (such as 401(k)s). Having a good understanding of the tax treatment of your ESOP funds will prevent you from a big tax surprise after a withdrawal.

ESOPs are powerful tools that can be used to maximize your earnings from a company. However, it’s important to understand funding methods, discounts, restrictions, and taxes as they pertain to your individual ESOP. These plans are written as contracts, which means it’s hard to talk generally about how to best utilize yours without knowing the specifics. If you have further questions about the ESOP at your employer, let’s talk about it!

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