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What Is an Employee Stock Ownership Plan (ESOP) – Definition, Pros & Cons


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There are several different types of plans available for employers that choose to reward their employees with shares of the company. However, there is only one type of stock purchase plan considered to be a qualified plan that is subject to ERISA guidelines: the Employee Stock Ownership Plan (ESOP).

Employers should not regard ESOPs as simply another means of rewarding employees with shares of stock – this unique form of employee stock ownership is fundamentally unlike any other form of stock option or qualified plan.

What Is an ESOP Plan?

ESOP plans are qualified retirement plans that are designed solely for the purpose of transferring shares of ownership of the company to both executives and rank and file employees. Although these plans are available for publicly traded companies, they are most commonly used by closely held businesses that need a liquid market for their shares. ESOP plans solve this problem by purchasing shares from employees enrolled in the plan when they retire.

Plan Structure and Design

ESOP plans are the only type of either retirement or employee stock purchase plans that holds either company stock or cash in a separate trust, where employees are the beneficiaries and stock is placed in their names in separate accounts. They are defined contribution plans, but differ from other types of defined contribution plans in that they can only be established by C or Subchapter S corporations (the latter are by far the most common type of ESOP owner). No other type of business entity may use them, such as partnerships, professional corporations, or sole proprietorships.

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To create an ESOP plan, the employer forms an ESOP committee, usually consisting of owners and key management members, and perhaps some key employees or a representative for rank-and-file employees. The committee makes decisions about how the plan will be funded and operated, and appoints a trustee to run the trust according to their specifications.


ESOP plans are also unique in that they are typically funded solely by employer contributions; although employee contributions are allowed, they are seldom required for this type of plan. The employer makes tax-deductible contributions into the employee accounts within the trust each year according to a preset formula, which is typically calculated according to some combination of employee tenure and compensation on an individual basis.

The total annual deductible contribution cannot exceed 25% of the total pay of all plan participants for a calendar year. Employers typically fund the plan with shares of their own stock that have been valued by an independent appraiser, but may make cash contributions as well, which is typically used to fund the repurchase of shares from employees when they retire.


ESOPs must obey the same rules as all other qualified plans when it comes to vesting and participant eligibility; any employee age 21 or older must usually be allowed to join the plan after completing 1,000 hours of service within a calendar year. ESOPs usually contain a vesting schedule that must be completed before employees can access the assets in the plan, which means that they must work for the employer for a certain number of years before they can take some (or all) of their plan assets with them if they go work somewhere else.

The vesting rules that were modified by the Pension Protection Act of 2006 now require employers to use either a three-year cliff (where the entire balance vests at that time) or a six-year graded vesting schedule (where 20% of the plan balance vests each year during years two through six under the latter schedule).


Employees who have participated in the plan for at least 10 years are allowed to diversify as much as a quarter of their plan assets into other investment vehicles when they reach age 55, and can diversify up to another 25% of their plan balance at age 60. The plan must either provide at least three other investment alternatives, such as mutual funds or bonds, or else permit the participant to roll over those amounts into another plan (like a 401k plan that is also offered by the employer). Participants may also take a penalty-free distribution of this amount if no investment alternatives are provided by the employer.


ESOP employees can take distributions from their plans under a number of different circumstances:

  • Retirement. Employees who reach either the normal retirement age of 59 1/2 or retire early at age 55.
  • Death and Disability. The age limits are waived in these instances.
  • Separation From Service. Employees who leave the company for reasons other than those listed above may have to wait up to five years to begin receiving distributions. They also may forfeit some or all of their plan assets if they are not fully vested in the plan when they separate from service.
  • Hardship. Employees can take a hardship distribution if permitted by the plan (the hardship must meet the plan’s criteria for this type of event).
  • Miscellaneous Conditions. Some ESOP plans will also allow participants to make distributions while still working for the company as long as they meet prescribed age or tenure requirements as set forth in the trust.

Distributions can be made in either a single lump sum or else over a period of no more than five years. Participants who own at least 5% of the company are also required to begin taking mandatory required minimum distributions from their ESOP plans on April 1st of the year following the year in which they turn 70 1/2, even if they are still working for the company. Distributions can also be delayed for participants if the ESOP is leveraged (meaning that it has purchased its shares of company stock using borrowed money) until the year after the year that the loan is repaid (an exception is made in the event of death or disability).

When participants begin taking distributions from the plan, the employer is required by law to make an offer to buy shares from the participant at a set price that must stand for 60 days. Then, the employer must repeat this process one year after the initial distribution period. Employees can make several sales during this period if they choose – but if they do not sell their shares within these time frames, the employer has no further obligation to buy them back. The employee may be effectively stuck with them, although they can sell their shares to any willing buyer for whatever price the buyer is willing to pay. Of course, if the company stock is publicly traded, then they can just sell the shares on the open market, but closely held businesses are required to hire an independent appraiser to periodically value the shares in order to determine the sale price.

It is often necessary to borrow money to cover the repurchase of shares into the plan, and the plan is allowed to obtain financing based upon the employer’s credit. The employer can then make further cash contributions into the plan that can be used to repay the loan. This type of contribution cannot exceed 25% of the total compensation of all plan participants.

Plan Structure Design

Tax Treatment

Distributions from ESOP plans are taxed in the same manner as all other qualified plans. Participants can begin taking  distributions from the plan at age 59 1/2 without penalty except in the event of death or disability, and distributions are taxed as ordinary income in the year they are taken. Early withdrawals are also subject to a 10% penalty.

Employees can receive capital gains treatment on the sale of company shares in their plan if they sell the stock under the Net Unrealized Appreciation (NUA) provision, which stipulates that any stock in a qualified plan that is spun off from any other types of assets in the plan and sold in a single transaction can receive capital gains treatment. Participants can also delay taxation by rolling the plan over to a traditional or Roth IRA (although the latter transfer would constitute a taxable conversion). However, dividends that are paid in cash to participants for their ESOP shares are fully taxable at the time they are paid, although there is no early withdrawal penalty assessed on them, and no tax of any kind is withheld.

Advantages of ESOP Plans

  1. Liquidity. ESOP plans create a liquid market for company stock that employees can use to sell their shares. This is especially beneficial for closely held businesses with non-publicly traded shares.
  2. Tax Advantages. The tax benefits that come with all qualified plans, such as tax-deferred growth and deductible contributions, also come with ESOP plans.
  3. Workforce Motivation. ESOP plans can result in increased employee retention and productivity due to shared ownership of the company. Several studies have shown that companies grow faster after they establish these plans.
  4. Voting Rights. Most ESOP plans give employees voting rights on the stock they receive.
  5. Dividends. Employers can pay employees dividends on the stock in the plan, which can be paid either directly in cash or used to purchase more shares of the company. ESOPs are the only type of tax-deferred retirement plan that can pay out cash of any kind to participants before they are otherwise eligible to take distributions without incurring a penalty.

Disadvantages of ESOP Plans

  1. Lack of Diversification. Because ESOP plans are usually funded entirely with company stock, employees can become very overweighted in this security in their investment portfolios. For this reason, most Sub S employers who offer this plan also offer another qualified plan, such as a 401k plan, as an alternative or supplement (employees can contribute to both at once), and the rules allowing for diversification at ages 55 and 60 were introduced.
  2. Lower Payout. The share price received by employees in a closely held ESOP may not be as good as what they would get if the stock were publicly traded.
  3. Limited Corporate Structure. ESOPs can only be used by C or S corporations.
  4. Cash Flow Difficulties. Employers may have difficulty covering the repurchase of large numbers of shares if several employees begin taking distributions at the same time.
  5. High Expenses. Companies that implement ESOP plans can incur very high creation and administration costs (usually starting at about $40,000).
  6. Share Price Dilution. Creation and issuance of additional shares for new participants can dilute the value of all existing shares, which is a bigger problem for closely held businesses.
Disadvantages Esop Plans

Final Word

ESOP plans were introduced in the mid-1950s as an efficient form of employee stock ownership. They came under the jurisdiction of ERISA in 1974 and have existed in their present form ever since. Although these plans do have some very real limitations, they can also provide employees with a substantial motivation to save for their retirements.

The National Center for Employee Ownership states that as of 2012 there are nearly 11,000 companies offering ESOP plans to about 10 million participants: 97% of these firms are closely held, and two out of every three use the plan as a way to buy back stock from their workers.

For more information on ESOP plans, consult a retirement plan expert or your financial advisor.


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Mark Cussen, CFP, CMFC has 17 years of experience in the financial industry and has worked as a stock broker, financial planner, income tax preparer, insurance agent and loan officer. He is now a full-time financial author when he is not on rotation doing financial planning for the military. He has written numerous articles for several financial websites such as Investopedia and Bankaholic, and is one of the featured authors for the Money and Personal Finance section of eHow. In his spare time, Mark enjoys surfing the net, cooking, movies and tv, church activities and playing ultimate frisbee with friends. He is also an avid KU basketball fan and model train enthusiast, and is now taking classes to learn how to trade stocks and derivatives effectively.