Employee Stock Options

Topics: Stock, Employee benefit, 401(k) Pages: 16 (4990 words) Published: April 15, 2013
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What is an ESOP?

ESOP stands for Employee Stock Ownership Plan and is an employee benefit plan which makes the employees owners of stock in that company. An ESOP is required by law to invest primarily in the stock of the sponsoring employer. An ESOP is a qualified defined contribution plan and is similar to profit sharing plans. The employer can use it as a conduit for borrowing money from a bank or other lending institution.

To set up an ESOP, the company creates a trust and makes annual contributions. Allocations can be in proportion to compensation, according to years of service, or a combination of both. Usually, an employee can join the plan after completing 1 year of service or 1000 hours of service within the year. When a participant in an ESOP plan has at least 10 years of service or reaches the age of 55, he/she must be given the option of diversifying his/her account up to 25% of the value. At the age of 60, the employee is given a one time option to diversify up to 50% of the account. This ruling of for ESOP shares allocated after December 31, 1986.

ESOPs are qualified employee benefit plans that exist in a highly regulated environment due to federal laws such as ERISA and federal regulatory agencies including the Internal Revenue Service and the Department of Labor. As a result, ESOPs require considerable advance planning to meet the legal requirements imposed on them and to satisfy the needs of employee participants. Our employee benefits specialists have provided counsel to numerous clients with ESOPs and can assist with the preparation, design and implementation of ESOP plans and trust arrangements. We have counseled organizations ranging in size from large public companies to small private and family owned businesses in connection with their ESOPs.

ESOPs: The Basics
An employee stock ownership plan is a kind of qualified employee benefit plan, meaning it qualifies for tax benefits if you abide by certain rules. A company sets up a trust fund for employees. The company then contributes cash to the trust so that it can buy company shares or just contributes shares. Alternatively, the trust can borrow money to buy shares, with the company repaying the loan by making contributions to the trust. Within limits, company contributions to the trust are tax deductible. Once shares are in the trust, they are allocated to accounts of at least all full-time employees (with some limited exceptions). They are then subject to vesting, and employees receive their shares when they leave the company. At that point, they can sell them back to the company or on the market, if there is one. Closely held companies must have their share price set by an annual outside appraisal. Employees own the shares through the trust, but closely held companies can control the voting of the trust on almost all issues if they so choose. Stock Options: The Basics

Stock options allow employees to purchase shares in their company at a price fixed when the option is granted (the grant price) for a defined number of years into the future. Option rights are usually subject to vesting.

For instance, a company may give an employee the right to buy 100 shares at the current price of $10 per share in 1998. The employee vests in this right over four years at 25% per year, meaning after the first year, options on 25 shares could be exercised. There is a time limit on the exercise, typically 10 years from the date of grant.

There are two main kinds of options, incentive stock options (ISOs) and nonqualified stock options (NSOs). With an ISO, if certain rules are met, the employee does not have to pay tax on the "spread" between the grant and exercise price until the shares are sold. Capital gain taxes would then be due. The company, however, cannot take a tax deduction for the spread. With an NSO, the employee pays taxes on the spread just as if it...
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