ESOP Defined
An Employee Stock Ownership Plan or an ESOP is the most distinctive of the group; it is a designated retirement plan that enables employees to become owners of stock in the company they work for, essentially turning employees into owners.
Within certain parameters, ESOPs have several tax advantages. One is deferred capital gains tax, which means owners can sell their stock to the company’s ESOP and roll over that liquidity into other investments. Another is the ability for companies to deduct dividends that are paid to plan participants; the dividends are exempt from income tax withholding. For S Corps in particular, ESOPs can have huge tax advantages. If an ESOP owns 100% of an S Corp, that company pays no federal income tax.
In addition to becoming a true stakeholder in the business, the major benefit to employees is that generally, there is no upfront cost for their shares since they are beneficiaries of the ESOP trust. It’s common for employees to vest shares over a certain period of time determined by their employer, and earn more shares over the course of their time at the company.
Because ESOPs are a retirement plan, it’s critical to remember that distributions are tied to age. Employees can usually only liquidate their shares without tax penalties upon retirement at a certain age, or if they leave the company at a qualified age, die, or become disabled.
ESO Defined
Employee Stock Options or ESOs are options that give employees the right to purchase company stock at a certain time and at a predetermined price. Two of the most common types of ESOs are Incentive Stock Options (ISOs) and Nonqualified Stock Options (NSOs).
A major difference to highlight between these two options is that ISOs are tax advantaged under certain conditions; for example, if an employee holds shares for a certain period of time after exercising the options, their increased value may be taxed as long-term capital gains. On the other hand, employees are taxed at ordinary income on the difference between the exercise price and market value at the time of exercise for NSOs.
ESOs are granted to employees to encourage them to help grow the company. The best case scenario for an employee is that they end up getting valuable company stock at a significant discount. After vesting and other parameters are met, an employee could either sell the stock on the open market (at which time they are taxed), or they can hold onto the stock. ESOs themselves can’t be sold on the open market, as the beneficial pricing and number of shares are meant to be benefits for employees or shareholders at a given company.
ESPP Defined
An Employee Stock Purchase Plan or ESPP is a company-run program that allows employees to buy company stock at a discounted price. This is most commonly enabled via payroll deductions between the date that the ESPP is offered and the purchase date.
Employees can purchase stock at up to a 15% discount compared to market rate. Unlike with ESOs or ESOPs, there is normally not a vesting period. However, there is usually a limited period of time during which an employee can purchase discounted stock. Some plans might also require employees to hold onto their newly purchased stock for a certain period of time in order to receive tax favorable treatment.
While ESOs carry no or little upfront cost to start, they can end up worthless if the stock price doesn’t rise above the strike price. ESPPs are more expensive since they involve the purchase of actual stock, but there is far less volatility risk when it comes to the value of the purchase.
