Both Employee Stock Ownership Plans and Incentive Stock Options seek to retain employees by tying benefits to company stock; there the similarity ends. The biggest difference between the two is that an ESOP is an IRS-qualified retirement plan, whereas an ISO is a type of executive compensation.
What is an ESOP?
An ESOP is an employer-sponsored retirement plan where shares of company stock are allocated annually to employee accounts. Employees must become vested in those shares, which means their ownership is contingent upon how many years they’ve been with the company. By law, they must be 100 percent vested after six years of continuous employment. ESOP benefits are available during retirement at which time they may be sold on the open market or bought back by the company that granted them.
What is an ISO?
ISOs are like executive bonuses. Options to buy company stock are rewarded based on company performance and typically exercised during employment. ISOs will have a maximum number of shares that can be purchased, a set price they can be purchased at and a date on which the option to purchase may be exercised – usually within a few years of the grant date. An ISO is not a retirement plan.
Tax Treatment: ISOs
Taxes on gains from ISOs and ESOPs are treated differently. Neither is taxed upon being granted, but either upon stock being sold (ISO) or distributed (ESOP). If you sell stock purchased from an ISO within one year of exercising that ISO, the gain will be treated as ordinary income. However, if you sell stock at least one year after the purchase date and two years after the option was granted, gains will be treated as long term capital gains, or taxed at 15 percent.
Tax Treatment: ESOPs
Since an ESOP is an IRS qualified retirement plan, no taxes are due until the plan is distributed. This will occur upon retirement, disability, termination or death. To avoid paying income tax on the entire amount, you can roll your ESOP into an IRS qualified plan, such as another employer's retirement plan or an annuity or IRA. If you're younger than 59½, this is necessary to avoid an early withdrawal penalty of 10 percent. To rollover your ESOP, it's very important that your company NOT distribute proceeds directly to you. The distribution needs to transfer directly to your new retirement plan, known as a trustee to trustee transfer. Otherwise, you could be levied hefty IRS penalties.
- IRS.gov: Topic 427 -- Stock Options; Updated March 2011
- ESOP Association: What is an ESOP?
- NCEO: ESOP Tax and Contribution Incentives
- Internal Revenue Service. "4.72.4 Employee Stock Ownership Plans (ESOPs)." Accessed Oct. 19, 2020.
- United States Code. "From Title 26-Internal Revenue Code, Subtitle A-Income Taxes, Chapter 1-Normal Taxes and Surtaxes, Subchapter O-Gain or Loss on Disposition of Property, Part III-Common Nontaxable Exchanges, §1042. Sales of Stock to Employee Stock Ownership Plans or Certain Cooperatives." Accessed Oct. 19, 2020.
Holly Mangan began writing in 2008. Her work has appeared in "Mariposa Spirit!" magazine and mariposaspirit.org. She's worked in finance for 4 years and graduated with a Bachelor of Science in chemistry from New College of Florida.