Understanding the Accounting for Employee Stock Ownership Plans (ESOPs)


Employee Stock Ownership Plans (ESOPs) are benefit plans enabling your staff to own stocks in your company. Generally, shares are offered at fair market value based on the duration of employment, unless there’s a public market for them.

There are numerous advantages to ESOPs, both for your staff and the company. These include increased employee productivity and retention, higher job satisfaction, and certain tax benefits. Such plans also provide a financing tool for your business, as you can sell stock to the ESOP and use the cash to pay off debt.

However, having ESOPs in place can affect your accounting practices, and tax filings. 


What are Employee Stock Ownership Plans?

ESOPs are usually set up as trust funds, with no up-front costs to the employee. They are held until your staff retire or resign, allowing your employees to earn an increasing proportion of shares for each year of their service. However, some businesses allow immediate vesting, or conveying of shares. Employee Stock Ownership Plans can be funded with newly issued or existing shares, or through borrowing money. 

Depending on your specific plan, when a staff member retires or resigns, you can buy back the vested shares. The money from this sale can be paid out to your employee in a lump sum, or periodically. Thereafter, these shares can be redistributed, or voided. 

When drawing up an ESPO, you’ll have to specify how it is administered, including how eligible employees are identified, the vesting period, and the processes to be followed when a staff member resigns or is let go.  

By offering your employees company shares, you incentivize your staff to ensure your business performs well. After all, as shareholders, your employees are personally invested in the company’s share price and performance.


Types of ESOPs and their common uses

While there are types of Employee Stock Ownership Plans, most companies will use one of six main structures. 

Employee Stock Option Scheme (ESOS)

An ESOS allows a staff member to purchase shares at a predetermined price, which is usually below market value. It can also let your staff participate in company profits, through dividends.

The plans are granted as part of a compensation package, through set payroll deductions or an annual payment, subject to performance goals over a vesting period. Moreover, they offer tax benefits, because taxes on these plans are deferred until the shares are sold

Restricted Stock Units (RSUs) 

RSUs are awarded as a promise of future shares after certain performance milestones are reached, or after your employees have worked for a designated amount of time. As such, they’re considered a form of deferred compensation. 

While this means that employees can access company equity without investing their own money or resources, RSUs come with significant tax consequences

Restricted Stock Awards (RSAs)

RSAs are subject to certain restrictions based on the vesting period and performance goals. They’re generally offered to executives or key employees, and can’t be sold until after they’ve been vested. Usually, these plans are more beneficial to privately held companies, that do not trade stock publicly. 

Stock Appreciation Rights (SARs)

SARs are payments based on the increase in value of your company stock over time. This means that you can give your staff stock benefits without them actually owning the shares, and diluting your equity. SARs are often granted to senior executives and key employees as a standalone plan or as part of a broader employee stock ownership plan.


It’s worth noting that SARs can’t be sold or transferred, and usually have a limited life span. Moreover, the price of these shares can’t be lower than fair market value. 

Phantom Equity Plans (PEPs)

PEPs allow employees to receive a payment based on the value of the company’s stock without actually owning any shares. Your staff are therefore given mock or “phantom” stock, based on the value and performance of your company’s real shares. These are typically paid out in cash. 

As such, they’re easier and cheaper to manage. Also, you’re not responsible for withholding taxes on the payments.

Direct Stock Purchase Plans (DSPPs) 

DSPPs let your employees purchase shares with their post-tax income. Here, stock is usually offered at discounted prices, directly from your company to a staff member. However, many companies also allow non-employees to participate. 


Financial Reporting for ESOPs

An Employee Stock Ownership Plan can have significant implications for your financial statements. For this reason, it’s important to accurately value ESPOs. This can be done in a number of ways, including a fair value determination. 

Many businesses use the Black-Scholes option pricing model or a binomial lattice model. Factors to consider include the market value of stock, their expected volatility, and expected dividends. 

No matter what type of ESOP your company offers, these need to be transparently disclosed on your financial statements, according to generally accepted accounting principles (GAAP) and  ASC 718-10-50-2(d)

How this is done depends on whether the plan is leveraged (in which the trust borrows money to buy stock) or non-leveraged (where your business contributes cash or shares directly to the ESOP). 

Under ASC 718-40, a leveraged ESOP debt is recorded as a liability, and compensation is recognized as a non-cash operating expense. As the debt is repaid, the liability is reduced and shareholder equity increases.

If recorded at the grant date, you won’t have an immediate entry. However if it’s done during the vesting period, you’ll debit ‘stock-based compensation expense’ and credit ‘additional paid-in capital – stock options’. The total expense allocated must be based on the fair value of the options at the grant date, which is amortized over the vesting period. 

Accounting for non-leveraged Employee Stock Ownership Plans is simpler, as they’re funded directly by your company through cash contributions or stock grants.  


The Impact of ESOPs on Your Financial Statements

Employee Stock Ownership Plans can affect your income statement, balance sheet, and cash flow statement. 

Income statement

ESOPs are recognized as non-cash expenses, which reduce your earnings per share (EPS). Overall, your income statement will reflect increased expenses and number of outstanding shares, along with decreased net income.

Compensation costs are reported as part of your employee benefit expenses under operating expenses. Interest is reported under non-operating expenses, and dividend income is reported under non-operating income.

Balance sheet

ESOP shares, debt, and expenses must be accounted for in your balance sheet, as they affect your liabilities and equity. Essentially, your balance sheet will reflect an increased liability, and decreased company equity. 

Your plan’s expense amounts are based on the cost of shares allocated, and are reported as a reduction of retained earnings in shareholders’ equity.

Cash flow statement

If your Employee Stock Ownership Plans pay out in shares, with no cash exchange, this will not affect your cash flow statement. However, the statement will reflect any contributions, dividends, and repayments made in cash. 

Contributions paid in cash flow from your operating activities, as they are part of employee compensation. Cash dividends are reported as income from investing activities, as they are a return on investment. Repayments in cash must be reported from financing activities, since they are part of a debt obligation.


For advice on how best to maximize an ESOP, and to find out exactly how these plans affect your financial statements, speak to one of our CPAs. 


Accounting Challenges and Considerations 

Employee Stock Ownership Plans can present several accounting challenges. This is mainly because of regulations set by accounting standards, and the complexities of integrating these rules into financial practices. 

This includes how to handle the valuation and dilution of shares. After all, ESOPs can affect your EPS or result in share dilution, which is critical for investor analysis. Moreover, how you handle your ESOP can affect your financial reporting and tax obligations. 

Best practices for mitigating risks 

Ensuring that you use software that can automate processes and conform to regulations, such as NetSuite or QuickBooks can go a long way in preventing the above-mentioned challenges. 

It’s also always best to consult with accounting and tax experts. They can help you ensure that you comply with GAAP, through establishing robust internal controls, and efficient accounting treatment for stock-based compensation.


Tax Benefits of ESOPs

Employee Stock Ownership Plans can affect your corporate income tax. According to the IRS, an ESOP is considered an IRC section 401(a) qualified defined contribution plan.

This offers a few benefits. For example, cash and stock contributions to ESOPs are tax-deductible, as are contributions used to repay any loans the ESOP takes out to purchase shares.

If you have an S Corp, the percentage owned by your ESOP is exempt from federal and most state income taxes, and your business can deduct contributions to the ESOP of up to 25% of eligible payroll. Essentially, this means you don’t have to pay tax on the percentage of your profits attributable to Employee Stock Ownership Plans.

A C Corp can also deduct contributions for principal payments on an ESOP loan. Under certain conditions, your dividend deductions are also tax-exempt. C Corps can even defer capital gains taxes on the proceeds of selling shares, in a 1042 rollover. IRC Section 1042 states that if the ESOP owns at least 30% of C Corp stock for at least three years, it’s possible to defer capital gains taxes indefinitely.

Compliance with IRS regulations and guidelines

Because Employee Stock Ownership Plans are subject to the Employee Retirement Income Security Act of 1974 (ERISA), they must meet specific requirements to maintain their tax-qualified status. This includes a plan document and distribution policy covering the established policies and processes, including vesting schedules and payout options.

To ensure that your ESOP is tax compliant, and for best accounting practices, schedule a Discovery Call with one of our CPAs.

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The information presented in this blog article is provided for informational purposes only. The information does not constitute legal, accounting, tax advice, or other professional services. We make no representations or warranties of any kind, express or implied, about the completeness, accuracy, reliability, suitability, or availability of the information contained herein. Use the information at your own risk. We disclaim all liability for any actions taken or not taken based on the contents of this blog. The use or interpretation of this information is solely at your discretion. For full guidance, consult with qualified professionals in the relevant fields.