But the true power of an ESOP lies in how it is structured. When it is done well, employees are empowered, businesses attract and retain top talent, and B-BBEE ownership targets are met. However, structuring them poorly could mean missed opportunities, tax inefficiencies, and unintended consequences.

Early definition of an ESOP’s objectives is crucial, as a clear purpose can serve as a useful guide in the selection of the most suitable and efficient structure. Achieving the balance between employee and business interests, as well as managing related tax considerations, demands careful planning and specialist insight. This article explores the principal factors to weigh when designing an ESOP, with the aim of delivering an effective and purposeful arrangement for all stakeholders.

Key structuring considerations for ESOPs

When establishing an ESOP, several fundamental structural decisions will determine both the effectiveness of the scheme and its tax and company law implications. These choices require careful consideration of the company’s specific objectives, the desired level of employee participation, and the optimal timing for tax events. Below, we outline some of the key factors that businesses must consider when designing their ESOP structure.

Vehicle of choice

An ESOP does not necessarily have to be housed in a vehicle such as a trust or company, but it is often useful to do so for administrative and grouping purposes, especially if it will involve a large number of participants. The choice between a trust and a company structure as the ESOP vehicle is fundamental and affects governance, tax treatment, and administrative complexity. Each option presents distinct advantages that must be weighed against the company’s specific objectives and circumstances.

The first consideration is weighing up the administrative burden of having to deal with either the Master of the High Court (in the case of trusts) or the Companies and Intellectual Property Commission (CIPC) in the case of companies. It is no secret that increasing challenges, inefficiencies, and delays are being experienced at the Master’s office across the country, and this unfortunately, has a knock-on impact when choosing the preferred vehicle. 

Notwithstanding this, a discretionary trust is often the preferred structure due to its inherent flexibility. Under this arrangement, trustees retain discretion over distributions to participants, allowing for responsive management of the scheme. From a tax perspective, benefits can be taxed in the hands of participants when trustees exercise their discretion to vest benefits during the year of assessment, potentially achieving more favourable individual tax rates. However, if benefits are not vested promptly (or appropriately), they may be taxed in the trust at the higher rate of 45%.

A vested trust, by contrast, provides greater certainty for participants, as they acquire legal entitlement to trust assets from the outset. All taxable amounts flow through to participants on a proportional basis, ensuring consistent tax treatment at individual rates. While this structure lacks some of the flexibility of a discretionary trust, it offers administrative simplicity and clear entitlements for participants. It also does not necessarily create adverse tax implications if structured appropriately.

Company structures, whether profit companies or non-profit companies, introduce additional complexity. A profit company allows participants to hold shares in the ESOP special purpose vehicle, providing clearly defined ownership rights and voting entitlements. However, this creates a second corporate layer with attendant ongoing company law obligations (which are generally more burdensome than trust law) and may result in double taxation on certain distributions. Non-profit companies are generally unsuitable for ESOPs due to statutory restrictions on distributions to members, directors, or persons appointing directors, which fundamentally conflict with the objective of providing economic benefits to employee participants.

The trust structure often emerges as the optimal choice for most ESOPs, balancing flexibility, tax efficiency, and B-BBEE compliance requirements.

Funding mechanisms for ESOPs

The funding structure of an ESOP significantly impacts both its commercial viability and tax efficiency. Companies must carefully consider how the acquisition of ESOP shares will be financed, as this choice affects cash flow, tax deductibility, and the overall economics of the transaction. Any funding structure may also need to be approved by shareholders under the financial assistance provisions of the Companies Act 71 of 2008 (Companies Act) (found in sections 44 and 45) unless the ESOP meets the criteria in the Companies Act and has a compliance officer as contemplated therein. To the extent that participants in the scheme are to receive loans from the company in their personal capacity, the National Credit Act must also be carefully considered, as recent case law has confirmed that this act is not limited to “ordinary course” lenders.

A notional vendor funding (NVF) structure is commonly employed, especially in a B-BEEE context. Under this arrangement, ESOP shares are issued at a nominal issue price (such as R1.00 in total), with the difference between the market value of the ordinary shares not subject to NVF and the issue price treated as an outstanding balance. The outstanding balance is then reduced due to a variety of factors, including dividends restricted on the NVF shares over the period with an embedded automatic repurchase of shares at maturity.

Alternatively, companies may choose full upfront funding, where the ESOP shares are acquired at market value using actual cash. However, this approach raises important structuring considerations regarding the source of funding. Companies must carefully evaluate whether to use loans, preference shares, or other financing mechanisms, each of which carries distinct legal, tax, and regulatory implications. Of particular note, recent amendments to section 8E of the Income Tax Act (as outlined in the 2025 Taxation Laws Amendment Bill) have refined the definition of ‘hybrid equity instrument’ to include instruments recognised as debt for financial reporting purposes, which may impact the tax treatment of certain funding structures. Companies should seek specialist advice to ensure their chosen funding mechanism aligns with their objectives while complying with applicable tax and company law requirements.

Both upfront funding and NVF structures can be used to achieve a range of objectives. In practice, however, NVF structures are often preferred as they allow companies to implement employee ownership schemes without the need for a significant upfront cash outlay, making them more commercially attractive for large-scale transactions. The other significant benefit is that NVF structures can provide downside protection without adverse tax consequences.

Real shareholding versus cash-settled schemes

The decision between providing participants with actual shares or cash-equivalent benefits fundamentally shapes an ESOP’s character and effectiveness. This choice may even affect employee motivation, tax obligations, administrative complexity, and the company’s ability to maintain targeted ownership levels. 

Real shareholding through the distribution of actual ESOP shares provides participants with genuine ownership rights, including voting entitlements and dividend receipts. This approach typically delivers stronger motivational benefits, as employees become true shareholders with a direct stake in the company’s performance. For B-BBEE purposes, actual share ownership by Black participants is readily recognised and contributes directly to ownership scorecards, making this structure particularly valuable for companies seeking to meet transformation objectives.

Despite these advantages, real shareholding presents practical challenges, particularly when participants need to realise value or settle tax obligations arising from section 8C vesting events. Market sales by participants to meet PAYE liabilities may result in a reduction of Black ownership levels below targeted thresholds, potentially undermining the transaction’s original B-BBEE objectives. In unlisted contexts, real shareholding creates additional complexities around liquidity and valuation without necessarily providing corresponding benefits. From a company law perspective, these dilutive share schemes require shareholder approval by special resolution if implemented by companies listed on the JSE (the so-called “Schedule 14” schemes)

Cash-settled schemes avoid the ownership dilution issue by retaining all ESOP shares within the trust structure indefinitely. Under this approach, participants receive cash payments equivalent to the market value of their notional shareholdings at predetermined dates, typically after deduction of applicable taxes. This structure simplifies tax settlement, as cash proceeds can be applied directly against PAYE obligations without requiring market transactions. Corporate law implications are also greatly simplified. From the company’s perspective, ownership levels remain stable and predictable and could provide for an income tax deduction for employers. However, cash settlement requires substantial funding by the company at maturity dates and may not qualify for the same level of B-BBEE recognition, as participants never acquire actual ownership of shares.

Hybrid approaches may also be considered, such as providing participants with a choice between cash and shares at vesting, or implementing mechanisms that encourage retention of shares while facilitating tax settlement. These might include company-funded loan arrangements for tax payments or internal markets where departing employees must first offer shares to remaining participants before an external sale.

The optimal choice depends on the relative importance of employee ownership, B-BBEE maintenance, and administrative simplicity within the company’s broader strategic objectives.

The taxation of ESOP participants: Dividend and vesting

The taxation of ESOP participants is shaped by two primary events: the receipt of dividends (or distributions more broadly) and the vesting of rights and benefits. The timing and nature of these tax events depend on the ESOP structure, the rights conferred, and the applicable tax legislation. Below are the principal considerations and influences on the taxation of ESOP participants, with reference to both trust and company structures.

Dividends

When it comes to dividends, the tax treatment will depend on the underlying structure of the ESOP. In a trust-based ESOP, for example, the distinction between a discretionary and a vested trust becomes important. If a participant acquires a vested right to a dividend in the same year that the trust receives it, the dividend is typically taxed in the participant’s hands as income. However, if the trust retains the dividend and does not vest it in the participant during that year, the trust itself may become liable for dividends tax. Any subsequent distribution to the participant could then be taxed as ordinary income at the participant’s marginal rate, raising the risk of double taxation if not managed carefully.

In contrast, where a company is used as the ESOP vehicle, dividends received from the underlying shares are generally exempt from dividends tax due to the company-to-company exemption. When the company distributes these amounts to participants, the tax treatment depends on the nature of the participants’ holdings: if participants hold restricted shares in the ESOP company, the distribution will be taxed as a dividend at the dividends tax rate; otherwise, it will be taxed as ordinary income at the participant’s marginal rate.

The timing of when a participant becomes entitled to dividends, the nature of the trust, and whether the ESOP structure provides for direct or indirect share ownership all play a role in determining the tax outcome. These factors must be considered at the design stage to ensure the scheme is both efficient and fair to participants.

Vesting

Taxation on the vesting of shares – often referred to as a section 8C event – arises when a “restricted equity instrument”, such as a share or “unit” held in relation to a trust but subject to restrictions, vests in the participant. As such, vesting typically occurs when all restrictions fall away or when the participant is allowed to dispose of the shares at market value. If all units or shares vest on a single date, this can result in a significant, simultaneous PAYE obligation, potentially leading to mass sales of shares to settle tax. By contrast, a staggered vesting schedule can help spread tax events over several years, giving participants more flexibility to manage their liabilities and reducing the risk of forced share sales.

It is also important to appreciate that the PAYE liability is a debt of the employee, and the employer cannot settle it on their behalf without triggering fringe benefits tax. This may result in an unnecessarily expensive tax bill, as one may have to gross up the relevant amounts.

The taxable gain on vesting is calculated as the difference between the market value of the shares at the time of vesting and any amount paid by the participant for those shares. This gain is included in the participant’s taxable income and is subject to PAYE withholding. The structure and duration of restrictions, the vesting schedule, and the mechanisms available for settling PAYE – such as selling shares, using dividends, or company-funded arrangements – all influence the timing and amount of tax payable.

Ideally, the design of the ESOP should aim to avoid double taxation and align the timing of tax events with participants’ ability to fund their tax liabilities. The choice between trust and company structures, and between real shareholding and cash-settled schemes, will shape both the timing and nature of tax for participants. By co-ordinating dividend policies and vesting schedules, companies can help participants manage their tax obligations efficiently and avoid forced share sales that might undermine the scheme’s broader objectives. For participants, understanding when and how tax arises is essential, as it can significantly affect the net benefit they ultimately receive.

Additional considerations

While the structural and tax considerations outlined above form the foundation of effective ESOP design, several additional factors warrant careful attention. Companies must consider the administrative burden of ongoing scheme management, including participant communication, annual valuations, and compliance reporting. The choice of trustees or directors for ESOP vehicles should focus on individuals with appropriate skills and independence, particularly where discretionary powers affect participant benefits. Exit provisions for departing employees – distinguishing between ‘good leavers’ and ‘bad leavers’ – can significantly impact both participant motivation and scheme sustainability. Companies should also evaluate whether vesting schedules align with retention objectives, as cliff vesting after several years may better serve long-term employee retention than gradual vesting arrangements. Malus and clawback provisions are also often overlooked in practice.

For employees considering ESOP participation, understanding the long-term implications is equally important. Participants should carefully evaluate their ability to meet potential tax obligations arising from vesting events, particularly where PAYE liabilities may require share sales or personal funding. The illiquid nature of unlisted company shares may limit exit options, making the company’s dividend policy and internal market mechanisms crucial considerations. Employees should also understand their rights and obligations as ESOP participants, including any restrictions on share transfers and the circumstances that might trigger forfeiture of benefits.

The potential requirement for a prospectus also needs to be looked at, especially if the employer company seeks to offer shares for consideration to a wide range of employees throughout the organisation. In the listed environment, participants must be educated on the various rules regarding insider trading and directors’ dealings – the employer should, in fact, have a policy in this regard.

Conclusion

The design of an effective ESOP requires careful navigation of competing objectives: economic and commercial success; employee motivation and retention; tax efficiency; and administrative practicality.

While there is no universal solution that perfectly balances all these considerations, thoughtful planning with reference to an organisation’s unique objective can create schemes that deliver meaningful benefits to all stakeholders. The key lies in clearly defining objectives from the outset and making informed structural choices that align with those goals. Organisations should appreciate that there are almost always commercial trade-offs when designing the most appropriate plan, and therefore, it is key that they prioritise what is most important.

Success in ESOP implementation ultimately depends on recognising that these schemes are not merely technical exercises in tax planning or King Code box-ticking, but strategic tools for building sustainable businesses and empowering employees. When properly structured and implemented, ESOPs can transform workplace culture, drive business performance, and contribute meaningfully to South Africa’s economic transformation agenda. The investment in careful design and professional guidance at the outset pays dividends through schemes that truly deliver on their promise of shared ownership and mutual prosperity.