Employee Stock Ownership Plans

An employee stock ownership plan (ESOP) it is a type of retirement plan that allows employees to own part of the company that the work for. ESOPs also have many tax benefits for both the employer and the employees. It could also be used as a corporate finance tool for mergers, acquisitions, and leveraged buyouts. An ESOP is a qualified retirement plan that must invest its assets primarily in the employer's securities. The ESOP is funded by the employer, sometimes in exchange for reduced compensation or reduced retirement benefits for the employees. Although like a stock bonus plan, a stock bonus plan is not required to invest in the employer's securities and an employer may not lend any funds or use its credit facilities for a stock bonus plan but can for a ESOP to finance the purchase of the employer securities. ERISA specifies how companies can use ESOPs to provide employee benefits, which is the same law that regulates qualified retirement plans, such as 401(k)s.

A business owner can use an ESOP to sell a closely held business to the employees that may be tax-free if the proceeds of selling the business to the ESOP is used to invest in another business. Within certain limits, an employer can deduct cash and stock or other property contributed to the ESOP.

An ESOP may be used to buy treasury stock, authorized but unissued stock, or stock owned by individuals, while still allowing the employer to maintain control. The deductible contributions may also prevent an accumulated earnings tax penalty. An ESOP also motivates employees since they will own a part of the business, sometimes a majority part. The estate of a major shareholder can also get money to pay estate taxes by selling stock to the ESOP for cash. Even if the employer is a private company, a shareholder can sell their stock to the ESOP.

An ESOP can also be used to buy life insurance on key employees, where the employer can make deductible contributions to the ESOP to pay the premiums, that would otherwise be nondeductible if the business bought the insurance directly. An employer can also get cash by selling corporate stock to the ESOP rather than contributing the stock. An ESOP can also be used to lower taxes on loans obtained from banks by contributing deductible payments to the ESOP, which, in turn, is used to repay the bank loan.

How ESOPs Work

ESOPs are designed to hold cash, cash equivalents, or the employer stock. A trust is set up as an employer stock ownership trust (ESOT) and may qualify as a tax-exempt employee trust. An employer makes tax-deductible contributions of stock or cash into a trust. Assets are allocated according to a formula to employee participants. Employees are not taxed on the contributions until they withdraw from the ESOP

Contributions are directly proportional to the plan participant's compensation, equal to the ratio of the employee's compensation divided by total compensation paid to all employees. An ESOP can also buy the stock of subsidiaries of the employer corporation if that parent owns more than 50% of the subsidiary's stock.

Leveraged ESOPs borrow money to buy their stock, which is repaid by the corporation making contributions to the ESOP, which is used to amortize the loan. The shares are released to employee accounts as they are paid for. Leveraged ESOPs are often used for leveraged buyouts.

ESOP Voting Rights

Because the stock of an ESOP is owned by the Employee Stock Ownership Trust, the employees will have limited or no voting rights based on their shares. Instead, the voting rights reside with the trustee of the ESOT, who, in turn, is appointed by a Board of Directors. The voting rights that employees do have is determined by the plan document and by state law, which varies.

Leveraged ESOP

There are also leveraged ESOPs that borrow money from a bank or other lender to buy securities of the parent corporation or of the employer or of an acquisition. Purchased securities are placed in a suspense account — unallocated shares — which are allocated to the ESOP participants as a loan is repaid, based on the compensation of each participant.

ERISA Requirements

Subject to ERISA (Employee Retirement Income Security Act), an ESOP has the same requirements that apply to other qualified retirement plans, including universal coverage, nondiscrimination, and must also follow the rules of forfeitures and sources of contributions. An ESOP can distribute employer stock or cash, but the participants must be allowed to acquire employer stock if they desire, unless the charter or bylaws restrict such ownership, in which case, they must be given the right to receive cash. However, as an individual account plan, the ESOP is not subject to the ERISA reporting requirements for a statement from an actuary and is also exempt from paying plan termination insurance premiums to the Pension Benefit Guaranty Corporation.

An ESOP must be in writing. The ESOT must be set up for the exclusive benefit of the employees and their beneficiaries, not for the employer. The ESOT must be a United States trust, not a foreign trust, and may be a shareholder of an S corporation.

The trustee may not pay more than the fair market value for the stock, which must be independently appraised annually if the securities are nonpublicly traded. If the stock is registered under the Securities Exchange Act of 1934, then the participants must have the right to vote the stock. If not so registered, and the plan holds more than 10% of its assets as employer stock, then the plan must allow participants to vote on major corporate issues, such as approving a corporate merger or consolidation, liquidation, dissolution, sale of substantially all assets of the trade or business, recapitalization or reclassification.

The value of the employer's stock must be appraised annually to determine the proper purchase price and should be done by a professional appraiser specializing in the type of company of the employer. The appraisal must be done even in those years when no stock is contributed to the ESOP, because ERISA requires that the value of the participants account be reported annually.

10-year participants must be allowed to diversify 25% of their account balances when they reach 55 and an additional 25% by age 60. A participant may elect to receive a distribution of the account balance that will start within 1 year after the plan year in which employment is terminated due to normal retirement age, disability, or death, or by the 5th plan year following the year when the employee separates from the company.

An ESOP can own stock in an S corporation only if the benefit of the employer securities does not accrue to a disqualified person in a non-allocation year, including an officer or director of the employer or a similar such position, any person who owns at least 10% of the stock in the employer's S corporation, and highly compensated employees earning at least 10% of the yearly wages of an employer. If deemed owned shares of S corporations attributed to disqualified persons result in a non-allocation year, then a 50% excise tax will be assessed. A nonallocation year occurs when disqualified persons are deemed to own more than 50% of the equity of the ESOP entity. Deemed owned shares include direct equity interests and synthetic equity, defined in Revenue Ruling 2003–6, Prohibited Allocations of Securities in an S Corporation, including NQDC plans, allocated or unallocated ESOP shares, phantom stock, restricted stock, qualified and nonqualified stock options, stock appreciation rights, warrants, and any other rights to acquire stock in the S corporation that sponsors the ESOP or any entity related thereof.

An ESOP of an S corporation does not have to distribute employer stock, since such a distribution may result in more than 100 shareholders, which violates a requirement of the S corporation that it can have no more than 100 shareholders. Instead, the ESOP can distribute cash equal to the fair market value of the stock.

ESOP Advantages and Disadvantages

ESOPs have several advantages, depending on the employer's industry and how they plan to set up:

There are also several disadvantages:

Employer contributions are not taxable to the participating employees and the trust assets grow tax-free. Employees only pay tax on distributions. Corporations may only deduct interest payments, but ESOP can deduct both principal and interest

Dividends paid by a corporation are nondeductible, but dividends paid by the employer on the ESOP shares, which is charged against retained earnings, is deductible to the employer if:

Dividends can be restricted to a class of stock just for the ESOP, so that all dividends paid by the corporation will be deductible. The corporation can even deduct dividends paid to the plan or to participants or beneficiaries that are reinvested in qualified employer securities if so chosen by the participants. However, dividends paid by an S corporation ESOP are not deductible.

If the ESOP pays at least 50% of the equity in the target company, then it can carry losses forward, which is usually limited for corporations when a change of control occurs. The corporation could deduct contributions to the ESOP within limits, even without profits when the contribution was made and may generate a net operating loss carryback yielding a tax refund.

Deductions of up to 25% of the total compensation may be paid annually to all participants in the plan. If the contribution is less than 25%, then the difference between the amount contributed and what could have been contributed can be carried forward to future years, allowing an increased limit for the deduction.

The employer can contribute stock, cash, or any other property. In the case of property, the deduction will equal the fair market value + any cash. However, if property is transferred rather than the employer stock or cash, then the corporation must recognize any gain on the property if it appreciated in value over its basis.

If a C corporation uses debt to purchase employer stock, the employer may contribute up to 25% to the ESOP to make principal payments on the loan. Employer contributions used to pay interest on the loan can also be deducted without limit. These deduction limits may not apply if more than 1/3 of contributions are allocated to key employees.

Under IRC §1042, stock sold to one ESOP and replaced by a certain time will allow the deferred recognition of gain if:

Distributions of stock and cash to plan participants as a lump-sum distribution will not be taxed on the stock until the participant sells the stock. Any subsequent appreciation will be treated as a long-or short-term capital gain based on the amount of time the stock was held after distribution. However, the cash and the amount that the employer paid for the stock that was distributed is taxed to the participant at the time of distribution.

However, any part of the distribution attributed to deductible employee contributions are not part of the lump-sum distribution that is taxed, but is taxed as ordinary income when received. If the distributions are received over a period of years, then the amount will be taxed at the ordinary income rate that was effective when distributed. Distributions from an ESOP to participants younger than 59½ are assessed a 10% excise tax.

If the employee lives in a community property state, then qualified plans, including ESOPs, are also considered community property in direct proportion to the number of years that the employee worked as a community property spouse over the total amount of time worked. So, if an employee was married for 10 years in a community property state and worked for the company for 40 years, then 25% of the qualified plan benefit is community property.

Using ESOPs for Corporate Finance

Buyouts reduces cash flow requirements since some employee compensation can be replaced by ESOP stock contributions, allowing both principal and interest to be deducted on loans to finance the buyout. ESOPs have also been used to buy divestitures of the parent company. A new company is created, which establishes the ESOP, which then borrows the funds to buy the shares of the new company. The domestic company contributes to the ESOP to finance the payment of principal and interest, which is deductible by the corporation. Sometimes an ESOP is used to buy a failing company, by exchanging wage concessions for stock, but this is especially risky for the employees, since if the company goes bankrupt, then the stock will be worthless.

An ESOP can also be used to raise capital, which saves on IPO flotation costs, such as banking fees, legal fees, and other expenses in issuing and selling IPO shares. ESOPs are sometimes used, especially those incorporated in Delaware, as an antitakeover measure. Delaware law provides that a buyer who purchases more than 15% of the firm stock may not complete the takeover for 3 years unless:

Although ESOPs do make it much more difficult for a company to be acquired, the courts may block the formation of an ESOP if it is done as a takeover is being effected.


The true advantages and disadvantages of ESOPs depends on the industry of the company, the quality of its management, and how the ESOP is structured. Some studies have found significant advantages while others, not so much.