Know the Difference: Employee Share Schemes (ESS) vs Employee Stock Ownership Plans (ESOP)

You’ve likely heard of the benefits of an Employee Share Scheme (ESS) and Employee Stock Ownership Plan (ESOP), two of the most common terms in employee ownership.

Some accountants or consultants use ESOP and ESS interchangeably and have many similarities. Both share the common goal of aligning employee interests with the company’s success. Employee ownership schemes create a sense of agency and investment in the company for staff, creating greater incentives for participation in the company’s financial success.

However, these employee ownership models differ significantly in structure, purpose, implementation, and tax implications. So, let’s delve into the distinctions between ESS and ESOP to help your team better understand each’s unique elements and benefits.

Employee Share Schemes (ESS) Definition and Purpose

Employee Share Schemes, also called Employee Share Purchase Plans (ESPPs), are mechanisms through which employees can acquire shares or options to purchase shares in their employer company.

A simple ESS is arguably the easiest and quickest to set up. For a smaller company, it can be ready to go in just a few weeks.

Key Features

1. Broad Accessibility: ESS programs are typically open to a wide range of employees, often including all eligible staff members.
2. Discounted Purchase: Employees can usually buy company shares at a discounted price, making it financially attractive for them to participate.
3. Regular Contributions: ESS plans are often funded through regular payroll deductions, making it convenient for employees to accumulate shares over time without administrative burdens.

Benefits

• Inclusive Ownership: ESS encourages widespread employee ownership, promoting a sense of belonging and shared responsibility.
• Immediate Benefits: Participants in ESS programs can typically see immediate financial benefits through discounted share purchases.

Employee Stock Ownership Plans (ESOP) Definition and Purpose

Employee Stock Ownership Plans (ESOPs) are comprehensive programs through which employees become beneficial owners of the company by allocating shares held in trust. A vesting period usually applies; a set length of time that an employee must remain with the company before they can exercise their options (i.e. buy the shares).

ESOPs are designed to create a sense of ownership and align employee interests with company performance. They are also commonly used as a retirement benefit.

Key Features

1. Trust-Based Ownership: ESOPs establish a trust that holds shares on behalf of employees. Over time, employees accumulate ownership in the trust, with the ultimate goal of becoming full owners.
2. Retirement Benefit: ESOPs often serve as a retirement benefit, allowing employees to cash out their shares upon retirement or another predetermined event.
3. Long-Term Focus: ESOPs emphasise long-term ownership, encouraging employees to stay with the company to fully realise the benefits of their ownership stake.

Benefits

• Alignment of Interests: ESOPs align employee interests with the company’s performance and long-term success, as employees directly benefit from increased share value.
• Retirement Security: ESOPs provide a valuable retirement benefit, ensuring employees have financial security in their post-retirement years.

Example 1: Employee Share Scheme (ESS) – Software Company

Imagine Sarah, a mid-weight software engineer working for a tech firm, KoderKraft Pty Ltd, who implements an Employee Share Scheme (ESS) to motivate and reward its employees. They set up the ESS for participation with any salaried employees and contractors interested in being involved.

• Participation: Sarah, with three years of service with KoderKraft, is instantly eligible to participate in the ESS. Sarah pays 85% of the market value upfront to acquire the shares, making the investment financially attractive.
• Engagement: The simplicity of ESS arrangements makes it easy for Sarah to understand her ownership stake in the company. She holds these shares. She attends KoderKraft’s general meetings, exercises her voting rights, and eagerly anticipates dividends.
• Cost: As the company grows and its value increases over the next five years, she decides to realise the value of the shares after the vesting date, providing her with a significant amount of the deposit to buy her first home.

Example 2: Employee Share Option Plan (ESOP) – Meditech Innovation Firm

Consider James, the lead researcher at InovaRabo Pty Ltd. The private, family-owned company opts for an Employee Share Option Plan (ESOP) to align senior leadership interests with the company’s success. The ESOP also provides a financial incentive for loyalty in an industry where competing firms often poach key talent.

• Participation: James can participate in the ESOP without specific participation requirements. He receives an ‘option’ to purchase ordinary shares at a fixed price of $2, which vest over time. James doesn’t ‘own’ the shares; he owns the ‘option’ to buy them for a set price in the future.
• Engagement: If he exercises his option when the shares reach $20, he can profit from the difference to his $2 buy-in. But with breakthroughs expected to pass human clinical trials, his hard work could see shares worth $50, $70, or even $100 as he moves closer to retirement age.
• Cost: If James does decide to exit the company earlier than expected, he can exercise his options on departure and pay the fair market value of the underlying shares.

Key Differences Between ESS and ESOP

What are the tax implications of ESS and ESOP in Australia?

Tax treatment can vary, and it’s essential to understand the specifics under Australian tax laws that differ between Employee Share Schemes (ESS) and Employee Stock Ownership Plans (ESOP) — for example, where Capital Gains Tax (CGT) may be applicable. Companies must comply with all relevant legislation, including the Corporations Act 2001 and the Income Tax Assessment Act 1997.

There are three main ways that tax may apply to the shareholder (employee):

1. Taxed upfront scheme: Employees must include their Employee Share Scheme (ESS) interest, whether an option or a share, in their assessable income for the year of acquisition.
2. Deferred tax scheme: Under this arrangement, the payable tax can be postponed for a maximum of 15 years, contingent upon meeting specific conditions outlined, allowing them to defer the taxation of the discount until a later date.
3. Start-Up Concession scheme: In this scheme, the discount is not treated as immediate income, exempting it from upfront or deferred income tax. Instead, the taxation occurs under the Capital Gains Tax provisions when the shares are eventually sold.

The Australian Taxation Office (ATO) provides guidelines and regulations related to employee share schemes. Seeking advice from tax professionals or consulting with the ATO can help ensure accurate compliance with Australian tax regulations.

Companies should also provide employees with clear and comprehensive information about the tax implications of participating in ESS and ESOP.

Your Succession Plus partner can help with presentations and literature to ensure complete plan comprehension, including understanding Tax-Deferred Contributions and Tax-Advantaged Distributions.

Reforms and Changes – Post-July 2022 Amendments for ESOP

Employee Share Plans became more popular for Australian businesses with the 2015 Tax Reforms and Startup Concession Scheme. The 2022 amendments mean an employee leaving the business is no longer an automatic tax trigger. Employees are only taxed on their options where they have received an actual (realised) benefit sufficient to cover the cost of that tax.

Unlisted companies also have the flexibility to attribute up to $40,000 annually for equity grants involving employee contributions, up from the previous limit of $5,000. The adjustment allows unlisted companies to structure more competitive equity packages, making them more appealing to potential talent and enabling them to compete better with listed companies.

To be eligible for the Startup Concession Scheme, the company creating the ESS must not be older than ten years (since incorporation), not be listed on the ASX, and not primarily profit from holding, selling, or buying investments, including securities and shares. Talk to your Succession Plus partner for more information on this scheme.

Choosing the Right Path for Employee Ownership

In summary, Employee Share Schemes (ESS) and Employee Stock Ownership Plans (ESOP) represent distinct approaches to employee ownership. Both can be ways to offer performance-based share options for my employees. ESS programs focus on immediate participation and financial benefits, while ESOPs offer long-term ownership and retirement security.

The choice between these two depends on a company’s goals, culture, and the level of employee ownership desired. Regardless of the path chosen, ESS and ESOP can be powerful tools for aligning employee interests with company success and fostering a sense of ownership among your workforce.

Craig West

Executive Chairman | Succession Plus

Craig West is a strategic accountant with over 20 years of experience advising business owners. His background as a CPA in public practice has provided invaluable experience in the key issues of concern to business owners.

In March 2014, Craig was appointed Executive Chairman of the SME Association of Australia, Australia’s largest small business organisation representing over 300,000 business owners.

In October 2014, he was awarded the Exit Planner of the Year at the Exit Planning Institute Annual Conference in Texas, USA, due to his innovative development of an exit planning process to help business owners maximise business value and achieve a successful exit.

Craig’s proprietary structure - a Peak Performance Trust - has won the Australia-wide award for the Employee Share Ownership Plan of the year twice in four years.

In November 2018, Craig launched SME Experts in partnership with Mark Bouris’ Mentored on Podcast One and quickly grew the monthly podcast audience to over 26,500 downloads; in October 2019, he released a new podcast focused on medium-sized businesses - Mid-Market Matters.

In July 2021, Craig joined the NSW Committee for STEP (Society of Trust & Estate Practitioners) – focusing on advising families across generations.

Craig has also launched a SaaS platform, Capitaliz (which captures the 21-step process), to assist other advisers internationally deliver advisory services at scale.

In November 2021, Craig was appointed Executive Chairman of NSW Leaders, a business mentoring group for leading NSW businesses.

In July 2022, Craig West received the award of Doctor of Business Administration for his research thesis titled “Examination of the key factors driving business exit options in Australian Small and Medium Enterprises.”

Craig is passionate about encouraging business owners to think strategically, maximise the value of their business and achieve a successful exit.