What Is an ESOP Plan?

by Diane Watkins
Employee owners are motivated and loyal.

Employee owners are motivated and loyal.

construction worker image by Greg Pickens from Fotolia.com

An employee stock ownership plan (ESOP) is a retirement plan that allows employees to own a share of the business they work for. The company contributes cash or shares of stock to a trust fund that will hold the employee shares. In most cases, employees are given shares when they meet the company plan qualifications. The ESOP is similar to a profit-sharing plan, except that the shares are held until the employee retires. Employees are part owners of the company with the right to vote their shares and have a say in major decisions of the company. According to the National Center for Employee Ownership, in publicly held companies employees vote their shares on all issues, while private companies must allow employees to vote on major decisions, such as a relocation or plant closure.

Function of an ESOP

ESOPs reward and motivate employees while providing a way for an owner to take cash out of the business or raise money for the purchase of equipment. The company sets up a trust fund to hold the shares of stock. The company can contribute money or shares directly, or the ESOP can borrow money to purchase shares from the owner. The company then makes tax-deductible contributions to the ESOP, which repays the loan. Using an ESOP, a retiring owner can take out money to fund retirement while transferring ownership and control of the business to the employees. Some owners contribute shares to an ESOP to provide retirement benefits for employees. Rarely, an ESOP raises money to save a failing company through an employee buyout.

Tax Advantages

ESOP contributions are tax deductible and employee-owned companies receive substantial tax benefits. Dividends paid on stock held by an ESOP are tax deductible. Employees receive dividends directly or as payments to the ESOP. Employees and the company benefit when dividends pay off loans used to purchase shares or employees voluntarily reinvest dividends in company stock. Retiring owners can sell shares to an ESOP without incurring a taxable gain, as long as the ESOP holds at least 30 percent of the company after the purchase and the owner reinvests the money according to the rules. Owners can pull cash out of the company and roll it into another retirement account, deferring the taxes on the proceeds, according to the ESOP Association.

Employee Advantages

ESOPs use an equitable formula to determine the extent of an employee’s ownership. Employees are eligible to participate when they reach the age of 21 and meet the minimum employment terms of the plan. The longer the employee stays with the company, the more shares they earn. When an employee retires or quits, he receives his shares. The company buys these shares back at full market value, providing for the employees retirement, while retaining employee ownership of the company.


ESOPs are expensive to set up and not practical for small companies. When a company grows and new employees are hired, the stock of existing employees becomes diluted. The company must have enough cash available to buy back the stock of retiring or departing employees. This can be a problem if many older employees leave at the same time or if the company does not have ample reserves to cover the cost of the stock. ESOPs are beneficial for employees when the company is profitable and stock values are rising. When a company is doing poorly, employees are exposed to the risk of losing their jobs and retirement funds at the same time. The timing of an employee retirement can have a major impact on the benefits they receive.

ESOPs versus Stock Option Plans

ESOPs are not the same as stock option plans. With an ESOP, the stock is usually given to employees and is held in trust. Stock option plans allow employees to purchase stock at a pre-determined price during the option period. Employees gain complete control of stock purchased with stock options. These shares are individually owned and can be sold at any time. Stock in an ESOP is held in trust for the employee and cashed out when the employee leaves the company.

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