A stock bonus plan is a type of profit-sharing plan paid in employer stock instead of cash. Stock bonus plans are qualified retirement plans, and like most other types of investment accounts, they have advantages and disadvantages.
What is a stock bonus plan?
A stock bonus plan is a defined-contribution profit sharing plan, to which employers contribute company stock. These are considered to be qualified retirement plans, and as such, they're governed by the Employee Retirement Income Security Act (ERISA). This means they are subject to the standard rules of retirement plans -- namely, no unqualified withdrawals are allowed before age 59-1/2 without a penalty, and participants must take required minimum distributions beginning at age 70-1/2.
Contributions to a stock bonus plan are discretionary, but they must be substantial and recurring. Further, stock bonus plans cannot discriminate toward highly compensated employees, such as executives. Annual contributions to a stock bonus plan are limited to 25% of each employee's total compensation.
Participants in a stock bonus plan receive pass-through voting rights for their shares and have the option to sell their shares to the employer, just like they would if they held a put option on the open market.
An Employee Stock Ownership Plan (ESOP) is a similar type of plan, but isn't exactly the same thing. These are offered by many private companies to promote employee ownership. To name a few well-known examples, Publix Supermarkets, Hy-Vee, and New Belgium Brewery all operate as employee-owned corporations through ESOPs. ESOPs have slightly different legal and tax implications than stock bonus plans. There is a thorough comparison on the National Center for Employee Ownership's (NCEO) website.
Advantages and disadvantages
There are a few advantages to offering a stock bonus plan to employees.
On the employee side, the advantage is that it gives workers a vested interest in doing a good job. The idea is that if employees perform at the peak of their potential, the company will become more profitable, the stock price will rise, and employees will reap the benefits. Stock bonus plans are also valuable tools for recruiting and retaining the best employees.
For employers, the value of the stock contributed to the plan is tax-deductible, just like contributions to employees' 401(k) accounts, as stock bonus plans are considered to be qualified retirement plans under ERISA.
The potential downside to stock bonus plans for employees is that a disproportionate amount of their retirement savings can be tied up in a single investment -- rarely a good idea. Many employers with stock bonus plans also offer 401(k)s or similar retirement options, and public companies are legally required to allow their employees to diversify out of a company's stock, but stock bonus plans still lead to a lack of diversification.
For employers, a major disadvantage is the liability the outstanding put options create. In other words, at any given time, the company could be obligated to buy the shares held in employees' accounts.
If you're looking to learn more about stocks in general, consider learning more about online brokerages.
This article is part of The Motley Fool's Knowledge Center, which was created based on the collected wisdom of a fantastic community of investors. We'd love to hear your questions, thoughts, and opinions on the Knowledge Center in general or this page in particular. Your input will help us help the world invest, better! Email us at firstname.lastname@example.org. Thanks -- and Fool on!
Try any of our Foolish newsletter services free for 30 days. We Fools may not all hold the same opinions, but we all believe that considering a diverse range of insights makes us better investors. The Motley Fool has a disclosure policy.