Implementing an Employee Stock Ownership Plan (ESOP) can be a transformative milestone for a company. It not only reshapes the ownership structure but can also redefine how employees engage with the business. As a company nears the end of the ESOP implementation process, designing the benefit plan features of the ESOP becomes a critical step—not just to meet regulatory requirements for a tax-qualified retirement plan, but to align with the company’s culture, strategic goals, and workforce dynamics.
The initial design of an ESOP lays the foundation for how employees will participate, earn allocations, vest in their benefits, and eventually receive distributions. These provisions not only influence the effectiveness of the ESOP as a possible retention and recruiting tool but may also have long-term implications that should be thoughtfully assessed by company leadership and their advisors. This article explores key plan design considerations to help companies evaluate how the ESOP can support the company’s business objectives and its people.
Choosing the Plan Effective Date: Retroactive or Current-Year Adoption
One of the earliest decisions in designing a new ESOP is selecting the plan’s effective date. This choice influences not only the timing of employee vesting, plan participation and share allocations but also the company’s financial and tax strategy. Companies typically consider two options: adopting the ESOP for the current plan year or retroactively for the prior year. Each approach carries distinct advantages and implications.
Retroactive Plan Year Adoption
Implementing the ESOP retroactively—often as of the beginning of the prior fiscal year—can offer tax benefits to the company and shareholder(s). If the ESOP is adopted by the company’s tax filing deadline (including extensions), it allows the company to claim a tax deduction for contributions made to the ESOP for that year. This can be especially valuable if the company had strong earnings and is seeking ways to reduce taxable income. Additionally, cash contributed to the ESOP for the retroactive plan year may be used to purchase shares from the selling shareholder(s) in the ESOP transaction.
Retroactive adoption also enables the company to communicate to employees that they’ve already begun to accrue share allocations and vesting credit for the prior year at the time of the ESOP rollout. This can help build early momentum for the ESOP, highlighting its value to employees and supporting a sense of ownership.
Current Plan Year Adoption
Choosing a current-year plan effective date may be the only option, particularly if the tax filing deadline has passed or entity restructuring prohibits adopting the plan for the prior year. Even if the plan cannot be adopted for the prior year, many companies adopt the plan retroactively to the first day of the current year. A current-year effective date can simplify plan administration and avoid the additional expense of recordkeeping for a retroactive plan year. Adopting the ESOP in the current year may be more appropriate if the company did not have meaningful taxable income to reduce in the prior fiscal year.
Determining Plan Entry: Employee Eligibility Criteria
Defining who is eligible to participate in the ESOP and how long it will take to become a plan participant are key decisions that determine when employees will receive their first ESOP statement. While regulatory guidelines set the outer boundaries, companies have flexibility to tailor eligibility rules to fit their workforce structure and cultural goals.
Eligible Employees
Excluding certain groups from the ESOP is standard and permitted under federal law, such as leased employees, independent contractors, nonresident aliens with no U.S. source income, and employees covered by a collective bargaining agreement that does not include ESOP participation. However, companies may also consider excluding other employee groups, such as interns, temporary workers, or employees in specific job classifications or locations. While these exclusions may be appropriate based on business objectives, they should be carefully evaluated to ensure compliance with IRS and ERISA protections for non-highly compensated employees.
Entry Requirements
Minimum employment thresholds are commonly applied before employees become eligible to participate in the ESOP. Under federal law, the maximum waiting period for ESOP participation includes:
- Completion of 1,000 hours of service within a 12-month period,
- Attainment of age 21, and
- Entry on the next semiannual date (January 1 and July 1 for a calendar year plan) following completion of the above.
This default structure is common but not mandatory. For certain organizations, such as those using the ESOP as a recruitment tool, a long waiting period can dampen enthusiasm and delay the sense of ownership. As a result, some companies adopt a design that allows earlier plan entry. Common alternatives include:
- Eligibility after a shorter period (e.g., 90 days) with monthly entry dates
- Lowering the minimum age requirement from 21 to 18
- Entry retroactive to January 1 of the year in which the employee completes 1,000 hours and 12 months of employment, rather than delaying plan entry until the next semiannual entry date
Companies establishing a new ESOP may also consider adopting special plan entry provisions for the plan’s initial year. This can allow employees who are already employed as of the ESOP’s effective date to enter the plan sooner than would otherwise be permitted under standard plan entry rules. A common approach is to establish a one‑time initial entry date for all active employees. Special first‑year entry provisions can help promote broad engagement and a sense of inclusivity during the initial ESOP rollout while also simplifying plan administration during implementation.
Concerns about short-tenured employees receiving ESOP benefits can be addressed through allocation and vesting rules. These rules, which will be addressed later in this article, may help address concerns about how benefits accrue for shorter-tenured employees.
It is important to understand that the rules for determining years of service for eligibility purposes are different from the rules for determining years of service for vesting purposes (discussed below). A newly adopted ESOP can provide that service before the plan’s effective date is not counted for vesting purposes, but prior service generally must be counted for plan entry purposes.
Allocating Shares: Allocation Requirements and Methods
Once eligibility is defined, the next design decisions include who will be eligible for the annual allocation of shares and how shares will be allocated among eligible participants.
Annual Requirements
Companies commonly require plan participants to work a minimum of 1,000 hours during the plan year and be actively employed on the last day of that year to qualify for a share allocation. While this represents the maximum threshold permitted by law, it can be adjusted to better align with a company’s workforce strategy and participation goals. These requirements are typically waived for employees who separate from service due to death, permanent disability, or reaching the plan’s defined retirement age during the year.
Allocation Methods
The most common method is allocating shares based on compensation. Under this approach, each participant receives a proportion of the total shares allocated for the year equal to their share of total eligible compensation. This method is straightforward for employees to understand and easy to administer.
The company also has discretion to define “eligible compensation,” which may include or exclude certain items such as commissions, bonus, or overtime pay (subject to nondiscrimination rules). Another alternative is to cap the compensation used for allocation at a level below the IRS statutory limit (i.e., $360,000 for 2026, indexed annually). For instance, a plan might exclude compensation above $150,000, which may help spread ownership more evenly among employees.
To reward tenure and loyalty, some companies adopt a “points” system that combines compensation and years of service. For example, participants might earn 10 points for each year of service and one point for every $1,000 of compensation. Shares are then allocated based on each participant’s proportion of total points. This hybrid approach can be useful in the early years of an ESOP, giving longer-tenured employees a larger initial allocation, and then transitioning to a compensation-only model over time.
In certain transactions, employers may choose to make a discretionary contribution to the ESOP as of the transaction closing date. When properly structured, a closing-date contribution can be allocated based on criteria specified by the company, allowing employees to meaningfully participate in ESOP ownership as of the ESOP effective date. An alternative allocation method such as this or a points system requires additional compliance testing to ensure it does not disproportionately benefit highly compensated employees.
While less common for ESOPs, the plan may also be designed to include employer matching or safe harbor contributions, similar to those commonly provided under a 401(k) plan. In some cases, companies choose to partially or fully shift matching or safe harbor contributions from an existing 401(k) plan to the ESOP. When structured appropriately, these contributions can enhance the ESOP benefit while allowing the company to deliver benefits in the form of shares rather than cash, supporting cash‑flow management.
Roth Contributions
Legislative changes enacted under the SECURE Act 2.0, signed into law in December 2022, expanded design flexibility for tax-qualified retirement plans by permitting employer matching and nonelective contributions to be designated as Roth contributions. Historically, ESOPs have been funded exclusively with pre tax employer contributions, deferring taxation for participants until benefits are distributed. SECURE 2.0 introduces the ability for companies to offer an optional Roth election feature within the ESOP, allowing participants to elect Roth treatment on certain employer contributions. An employee may only designate a contribution as a Roth contribution if the employee is fully vested in the contribution at the time it is allocated. Additionally, the Roth election must generally be made before the contribution is allocated. Unlike traditional pre tax ESOP contributions, a Roth contribution is included in the participant’s taxable income at the time of contribution, but qualified distributions, including earnings, are received tax free if applicable age and holding period requirements are met.
Allowing employees to elect Roth treatment on ESOP contributions can offer another retirement and tax planning option for employees. However, adopting a Roth feature introduces additional complexity and cost, requiring careful consideration of employee communication, ESOP recordkeeping, and reporting requirements. As with any new or bespoke plan design feature, this option should be evaluated in coordination with experienced ESOP, tax, and legal advisors.
Vesting
Vesting determines when employees earn a non-forfeitable right to the shares allocated to their ESOP account. Vesting is a key mechanism for encouraging retention and rewarding long-term commitment, while also protecting the company from granting full benefits to short-tenured employees.
Common Vesting Structures
Many ESOPs use a six-year graded vesting schedule, which gradually increases an employee’s vested percentage based on years of service:
- 0% vested until two years of service
- 20% vested after two years
- 40% after three years
- 60% after four years
- 80% after five years
- 100% after six years
This structure is widely adopted because it balances employee access with retention considerations. It requires that employees remain with the company for a meaningful period before fully owning their ESOP benefits.
The next most common vesting structure is a three-year cliff schedule, where employees are 0% vested until they attain three years of service, when they become 100% vested. This vesting schedule is easy to administer and allows the company to pay no ESOP benefits to employees who leave before accruing three years of vesting credit.
Shorter vesting schedules are also permissible, provided they are at least as favorable to employees as the schedules described above, such as a four-year graded schedule with 25% vesting earned each year or a two-year cliff schedule providing 100% after two years.
Excludable Years of Service for Vesting
When establishing a new ESOP, companies may also consider whether to grant prior service credit for years worked prior to the plan’s effective date. Providing vesting credit for prior service can acknowledge employees’ past contributions and may help build goodwill at the outset of the ESOP. This approach does not need to be all-or-nothing; many plans provide partial service credit. Common design alternatives include capping the amount of pre-ESOP service (e.g. granting up to two years of vesting credit for prior service) or awarding vesting credit on a proportional basis, such as one year of vesting for every five years of service completed prior to the ESOP’s effective date. In evaluating these options, companies should balance recognition of prior service with retention objectives and the financial impact associated with accelerated vesting.
Additionally, plans may exclude years of service for vesting purposes that were completed before an employee reaches age 18. This exclusion helps avoid complexities associated with providing vested benefits to minors.
It is a common misconception that vesting credit only begins when an employee becomes a participant in the ESOP. Instead, once the plan’s vesting age requirement is satisfied (which may not exceed age 18), employees generally begin earning vesting service upon hire—even if they are members of an excludable class or have not yet met the plan’s eligibility or entry requirements.
Measuring Years of Service
The ESOP must also define how a “year of service” is measured for eligibility, vesting and allocations. Federal regulations allow flexibility in this area, and the method selected can affect both administrative complexity and employee outcomes. The two primary approaches are the hours-of-service method and the elapsed time method.
Under the hours-of-service method, employees earn a year of service by completing a specified number of hours—no more than 1,000 hours—within a designated 12‑month period, typically the plan year. This approach ties service credit directly to hours for which the employee is paid or entitled to payment and is the most commonly used method. In contrast, the elapsed time method measures service based on the period of employment between an employee’s hire date and severance date, without regard to hours worked. While less frequently used, the elapsed time method may change vesting outcomes and is generally less suitable for organizations with frequent employee terminations and rehires.
Vesting Considerations
When determining the appropriate vesting schedule, companies should consider employee turnover trends and how vesting can be structured to support targeted retention goals. In addition, some organizations choose to align their ESOP vesting provisions with those used in other company-sponsored retirement plans, such as a 401(k). This alignment can create consistency across benefit programs and reinforce patterns and expectations employees already recognize.
It is also important to understand that an employee’s vested percentage typically applies to all shares held in their ESOP account. Newly allocated shares generally do not begin a separate vesting schedule but instead follow the same vesting percentage applicable at that time.
Most plans waive vesting requirements in cases of death, disability, or retirement, allowing affected employees to become fully vested regardless of service length. These exceptions reflect common industry practices and demonstrate the company’s commitment to supporting employees through life transitions.
Distribution Rules
Distribution rules govern how and when employees receive the value of their ESOP accounts after leaving the company. These provisions are essential for managing cash flow, setting employee expectations, and ensuring compliance with regulatory requirements.
Standard Distribution Timing
Distributions to participants who separate from service due to retirement, death, or disability must be offered beginning in the plan year following the employee’s separation from service. For employees who terminate for other reasons, such as normal turnover, distributions may be deferred for up to five plan years after separation, at the company’s election.
Plans may also include a small‑balance force‑out provision, which allows vested account balances below a specified threshold—commonly $7,000—to be distributed automatically without participant consent. This provision helps reduce the number of small, inactive accounts maintained by the ESOP.
Lump Sum v. Installments
ESOPs are permitted to distribute benefits in installments rather than as a single lump sum. Payments are generally made in substantially equal installments over no more than five years. For large balances ($1,455,000 or more, for 2026, indexed annually), the five-year installment period can be extended by one year for each additional $290,000 (or fraction thereof) by which the balance exceeds the base threshold for up to an additional five years (for a maximum installment period of 10 years). Installment distributions are a common design feature used to manage the company’s ESOP share repurchase obligation while still providing participants with a predictable stream of payments.
A company’s ESOP repurchase obligation is its future financial obligation to buy back ESOP shares from participants or their beneficiaries when those shares are distributed and cannot continue to be held by the former employee under the terms of the plan. Practically, it represents the cash the company will need to provide over time to redeem shares from retiring, disabled, deceased or terminated employees who become entitled to distributions from their ESOP account.
Participant Account Investments
Generally, ESOPs must be invested primarily in company stock. It is important to note that an ESOP participant’s balance does not freeze upon termination of employment. While the participant’s account remains invested in company stock, its value will continue to fluctuate with changes in the share price. To address this, plans may include a provision that allows the company to convert a terminated participant’s stock balance to cash or another non-stock investments. Once converted, the participant is no longer subject to gains or losses of the company stock, though it does require the company to contribute cash to fund the conversion from company stock into other types of investments.
Companies often adopt a distribution policy to govern how and when distributions are paid. This policy allows for flexibility to adjust distribution practices over time in response to changes in workforce dynamics, ESOP participant demographics, and company cash‑flow considerations.
Diversification Rights
ESOPs provide for statutory diversification rights, which allow eligible participants to diversify a portion of their account balance held in company stock into other investments over a six-year period. The six-year period begins upon attaining age 55 and completion of 10 years of participation in the ESOP (not 10 years of service). During the first five years of eligibility, participants may elect to diversify up to a cumulative 25% of the ESOP stock value held in their account, with the opportunity to diversify an additional 25% in the sixth and final year. Diversification is typically satisfied by transferring the value to another qualified plan or receiving a distribution. These diversification rights allow participants to reduce concentration in employer stock and diversify their retirement portfolios as they near retirement age.
No In-Service Distributions
Unlike 401(k) plans, aside from diversification rights, ESOPs generally do not permit other in‑service distributions or hardship withdrawals. Benefits are typically payable only upon a distributable event, reinforcing the ESOP’s role as a long‑term ownership and retirement vehicle rather than a short‑term savings arrangement.
Defining Retirement and Disability
To qualify for the special rules applicable upon retirement or disability, participants must satisfy the plan’s defined criteria. While these definitions are not required to mirror other benefit plans, many companies choose to align them with their 401(k) plan. Doing so can simplify plan administration, improve communication, and support consistent expectations across the company’s retirement programs.
Retirement
An ESOP’s retirement definition includes an age requirement—no higher than age 65—and may also incorporate a service or participation requirement, up to five years. Most commonly, retirement is defined simply as attainment of age 65. However, plans may adopt additional conditions, such as requiring both age 65 and five years of participation in the ESOP. Plans may also be designed more generously by defining retirement as an earlier age, such as age 62, often in combination with a shorter participation requirement.
Disability
Plans have flexibility in establishing the definition of disability, provided it is applied consistently. Common approaches include defining disability as eligibility for Social Security Disability Insurance, qualification for benefits under the company’s long term disability insurance plan, or another objective standard approved by the plan administrator. Some plans reserve discretion for the plan administrator to determine disability based on medical evidence or other reasonable criteria, allowing flexibility in circumstances where formal benefit determinations are not available.
How BDO Capital Advisors Can Help
Thoughtful plan design is central to the long term success of an ESOP. Decisions around eligibility, allocations, vesting, and distributions shape how effectively the ESOP supports the company’s broader objectives. When these features are intentionally aligned with workforce dynamics, company culture, and financial goals, an ESOP can serve as a powerful tool for engagement, retention, and shared ownership.
For companies considering an ESOP, early attention to plan design allows leadership to anticipate administrative, financial, and employee related impacts and to build a benefit structure that evolves alongside the business. If you are evaluating a new ESOP for your business or refining an existing plan, BDO Capital Advisors can provide guidance on these design considerations and develop an approach that aligns with your business goals.
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