What are Employee Stock Ownership Plans (ESOPs)?

An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that provides employees with ownership interest in the company. Companies might consider establishing an ESOP as a way to transition ownership, reward employees and preserve the company's culture. ESOPs can also serve as an effective employee retention tool, fostering a deeper connection between employees and the company. These plans offer distinctive financial benefits to both employees and business owners, though they come with specific administrative and operational costs.

How ESOPs work

ESOPs are structured as fiduciary trusts that hold company shares for employees. The trust can be funded through loans taken out by the ESOP, cash contributions from the company or direct contributions of stock by existing shareholders. Over time, employees receive shares, often based on factors like tenure or salary. The ESOP’s trustee is responsible for managing the trust in the best interest of the employees, including voting on corporate matters and ensuring fair share valuation.¹

Advantages for business owners

For business owners, selling to an ESOP offers several tax benefits. Under Section 1042 of the Internal Revenue Code, if certain requirements are met, owners of  stock of domestic C corporations that are not publicly traded may be able to defer capital gains tax if they reinvest the sale proceeds in Qualified Replacement Property (QRP) like U.S. large-cap domestic equities. Selling to a third party, by contrast, would generally trigger immediate capital gains tax. Additionally, companies structured as S corporations can become partially or fully exempt from U.S. federal and state income tax if owned by an ESOP, providing significant tax savings on company earnings.²

ESOPs also create an internal market for company shares, which can be advantageous for owners who face limited external buying interest. Selling to an ESOP helps preserve the company’s legacy and culture, avoiding potential disruptions that might come with a sale to a competitor or private equity firm.

Advantages for employees

For employees, ESOPs offer a valuable retirement savings vehicle. As employees accumulate shares in the company, the value of their ownership stake can increase with the company’s success, creating substantial wealth over time. Additionally, the tax-deferred growth of their ESOP accounts means they won’t pay taxes until they begin receiving distributions, which can often be rolled into an IRA. Employees should note that distributions from an ESOP generally happen after you quit, retire or die. In the latter case, your ESOP shares may be willed to survivors who may receive preferential tax treatment on their shares.³

Beyond financial benefits, ESOPs foster a culture of ownership, where employees feel directly invested in the company's performance. This sense of ownership can lead to improved job satisfaction, productivity and loyalty. Companies with ESOPs often experience reduced turnover as employees become more engaged and connected to the company’s long-term goals.

Considerations for implementing an ESOP

Setting up and maintaining an ESOP is complex and requires significant administrative oversight. As an ERISA-qualified retirement plan, ESOPs must adhere to stringent compliance standards. Companies must engage external advisors, including trustees, administrators and attorneys, to manage ongoing plan administration, valuation and record-keeping.

A critical obligation for ESOPs is the "put option" under IRS Section 409(h), which mandates that companies repurchase shares when participants exit the plan. This requirement can strain a company’s liquidity, especially if financial conditions deteriorate. Relatedly, annual valuations are required to determine the fair market value of the shares, impacting both sellers of shares to the ESOP and employees from which shares are repurchased when they exit the plan. For sellers, company devaluation can alter tax liabilities, while employees may face reduced account balances if the company’s valuation declines.

The bottom line

ESOPs offer distinctive benefits to both business owners and employees by facilitating ownership transitions, enhancing retirement savings and fostering an engaged, ownership-driven workforce. For owners, ESOPs provide an opportunity to gain tax advantages and ensure the continuity of their company’s culture and values, while employees gain a direct stake in the company’s success, leading to potential wealth accumulation and a more fulfilling work experience.

However, businesses should carefully consider the financial and administrative responsibilities that come with establishing an ESOP, as these obligations may require substantial upfront costs and ongoing commitment. By weighing the long-term benefits against invested resources and compliance demands, companies can determine if an ESOP aligns with their succession and employee engagement goals.