ESPP vs. ESOP | SmartAsset

In today’s dynamic job market, companies are constantly searching for innovative ways to attract, motivate and retain top talent. Two increasingly popular methods that bridge the gap between employees and corporate success are employee stock purchase plans (ESPPs) and employee stock ownership plans (ESOPs). These acronyms may sound similar, but they represent distinct strategies that grant employees a piece of the ownership pie. ESPPs allow employees to buy shares of stock at a discounted rate, while ESOPs offer stock or shares at no cost. Here is an explanation of both plans and the key differences. You can talk to a financial advisor to better understand how your participation impacts your long-term financial goals.

What Is an Employee Stock Purchase Plan (ESPP)?

An employee stock purchase plan (ESPP) is a company-sponsored benefit program that allows eligible employees to purchase company stock at a rate lower than the current market price. Here’s how it works:

Stock Discount

The ESPP discount on stock purchases can range from 5% to 15% or more, depending on the plan. ESPPs are a popular way for companies to offer an attractive benefit, encourage employee ownership and align the interests of employees with those of shareholders.

Qualified vs. Non-qualified

ESPPs come in two forms: qualified and non-qualified. Qualified plans require shareholders’ approval before implementation and must follow specific guidelines. Specifically, the offering period can be up to three years and discount maximums are usually lower. Plus, employees must hold purchased stock for a certain period, often a year, before selling.

On the other hand, non-qualified ESPPs have fewer rules and can provide bigger discounts. In addition, employees can sell their shares at any time, creating different tax consequences.

Eligibility and Contributions

ESPPs have specific eligibility requirements that employees must meet to participate. For example, employees usually must work for the company for a certain period (e.g., six months) and be full-time. Participants contribute to the ESPP through regular payroll deductions made over a set offering period. This period is typically between six months and three years. In addition, the IRS limits each employee to putting $25,000 per year into an ESPP.

Purchase and Timing

At the end of each offering period, the company uses the accumulated contributions to purchase company stock on behalf of participating employees. Generally, the price per share is the lowest between the stock price at the beginning and end of the offering period.

Tax Implications

The taxation for ESPPs is complex, as it combines ordinary taxes and capital gains taxes. Employees will incur taxes for ESPP participation the year they sell their stock, paying regular income taxes on the discount they receive. Then, they’ll pay capital gains taxes on the remaining gain. Specifically, short-term capital gains taxes (identical to regular income taxes) are due if the employee held the stock for less than a year while selling after one year incurs long-term capital gains taxes (which has its own unique bracket).

What Is an Employee Stock Ownership Plan (ESOP)?

An employee stock ownership plan (ESOP) is a qualified retirement plan that provides employees with an ownership interest in their company. ESOPs are a unique and innovative way for employees to acquire a stake in the corporation’s success. Here are the key features of ESOPs:

Ownership Structure

A company creates an ESOP as a trust holding shares of the company’s stock on behalf of its employees. Employees don’t purchase the stock. Instead, the company expends its own resources to fill the trust with stock. Employees become owners of these shares, but a trustee appointed by the company’s board usually manages the ESOP’s fiduciary responsibilities.

Employee Participation and Vesting

ESOPs typically cover all eligible company employees, often with certain minimum service requirements. This means that most employees, not just executives or management, can become shareholders in the company.

Like traditional retirement plans, ESOPs often have a vesting schedule that determines when employees gain full ownership of their allocated shares. Vesting can occur gradually over a number of years (for example, by vesting 20% per year for five years) or instantly (i.e., employees are 0% vested until completing five years of employment, at which time they become fully vested).

Retirement Benefit

ESOPs act as retirement benefit programs. Employees accumulate shares in their ESOP accounts over time and when they retire, they sell their shares back to the company at their fair market value. The proceeds from the sale then become part of the employee’s retirement income. Employees can also roll over their ESOP funds into an IRA if they wish.

Tax Advantages

ESOPs offer significant tax benefits for companies and employees. Contributions to the ESOP trust are often tax-deductible for the company and employees defer taxes on their holdings until they receive distributions. As a result, ESOPs have similar tax implications to a traditional 401(k) or IRA. However, because ESOPs are qualified retirement plans, employees receiving distributions before age 59.5 will incur an additional 10% penalty.

ESPP vs. ESOP: Investment Guide

ESPPs (employee stock purchase plans) and ESOPs (employee stock ownership plans) have some similarities but primarily serve different purposes within a company’s compensation and ownership structure. Here’s a comparison between investing in an ESPP versus an ESOP:

Ownership Stake: Both ESPPs and ESOPs provide employees with some form of ownership in the company, aligning their interests with those of shareholders. However, ESOPs allow employees to purchase and hold stock, while ESPPs grant shareholders the cash value of a specific number of allocated shares upon retirement.
Employee Participation: Both plans are offered to eligible employees as part of their compensation package. However, some ESPPs allow employees to opt-out, which they may choose to avoid lowering their paychecks. Conversely, ESOPs don’t require payroll deductions from employees because the company funds the trust.
Taxation: ESPPs and ESOPs offer tax advantages, although the specific tax treatment differs. Specifically, ESPPs create regular and capital gains tax implications depending on when the employee sells their stock. On the other hand, ESOPs create retirement income similar to a traditional 401(k) or IRA, meaning income taxes are applicable to distributions.
Acquisition: ESPPs allow employees to purchase company stock through payroll deductions at a discounted rate, often to encourage ownership and provide a financial benefit. ESOPs, on the other hand, are qualified retirement plans providing employees with a retirement benefit and a means for employee ownership succession in the company.
Timing and Use: ESPPs usually have shorter offering periods (typically six months to three years) and are not necessarily tied to retirement. However, ESOPs are long-term retirement benefits, with employees selling their shares upon retirement or leaving the company.
Vesting: ESPPs don’t have vesting periods but may require employees to work for a specified period before participating in the plan. Then, the offering period lasts months or years, during which time the employees put money towards the stock purchase. In addition, qualified plans require employees to hold their stock for a certain amount of time before selling. In ESOPs, vesting schedules determine when employees gain full ownership of their allocated shares and are often based on years of service.

Bottom Line

Couple looking at their ESOP and ESPP options

Employee stock purchase plans (ESPPs) and employee stock ownership plans (ESOPs) offer distinct paths to employee ownership within a company. ESPPs focus on short-term benefits, allowing employees to purchase discounted company stock and granting flexibility for selling it. On the other hand, ESOPs are long-term retirement plans that provide employees with an ownership stake in the company.

Tips for ESPPs and ESOPs

Buying stock through your ESPP and taking a payout from your ESOP both have tax consequences. In addition, they aren’t the only investment opportunities available to employees at successful companies. Finding a financial advisor doesn’t have to be hard. SmartAsset’s free tool matches you with up to three vetted financial advisors who serve your area, and you can have a free introductory call with your advisor matches to decide which one you feel is right for you. If you’re ready to find an advisor who can help you achieve your financial goals, get started now.
If you advance up the corporate ladder, you may have access to a distinct form of compensation known as phantom stock. While this plan doesn’t grant corporate ownership, it can become a fruitful piece of your retirement plan.