What Is an ESOP?

Learn more about how an employee stock ownership program can improve employees' work efforts, build loyalty, and create new transfer opportunities for retiring business owners.

An employee stock ownership program (ESOP) is a program that allows employees to purchase stock in the companies they work for. ESOPs can improve employees' work efforts, provide an incentive for employees to stay at a company, and allow retiring owners to transfer shares of stock to employees.

While ESOPs have many benefits, they aren't cheap. Setting up an ESOP can cost tens of thousands of dollars for small- to medium-size companies, and administration fees typically range from $3,000 to $10,000 a year.

If you decide an ESOP is right for your company, you'll have to create a trust and make annual contributions to employees' accounts within that trust. By law, ESOPs must invest primarily in the securities of the sponsoring company. Like 401(k) plans, ESOP accounts receive tax-deferred status until the participating employee retires.

Companies that start ESOPs usually hire consultants to help them design their plans. Some of the decisions you and your consultant will have to make include:

• Who will be eligible to participate in the plan?
• How will the company allocate stock?
• What will the plan's vesting schedule be?

After you've decided on the features of your ESOP, your attorney must draft a document that outlines the plan's rules. You'll also need to choose a plan trustee and a plan administrator. Trustees can be staff members, such as a CEO, or external entities, such as a bank or trustee company.

When employees leave your company, they are entitled to the vested portion of their account. Employees of public companies simply retain ownership of their stock with the option of selling it on the open market.

If you own a private company, however, you'll have to purchase ESOP stock from departing employees. This means your company must keep enough cash reserves to make these purchases. Private companies with ESOPs also need to hire independent appraisers to determine their stock value each year.

The IRS and the Department of Labor regulate ESOPs, which the Employment Retirement Income Security Act (ERISA) codified into law in 1974. For companies to reap the tax benefits of their ESOPs, they must comply with all IRS and Department of Labor regulations. Tax advantages for companies with ESOPs include:

• Contributions are tax-deductible within certain limits.
• Sponsoring companies can borrow against their ESOPs. Principal and interest on ESOP loans (leveraged ESOPs) are tax-deductible.
• Owners can sell their shares in an ESOP without incurring taxes, as long as they roll the money into qualified U.S. securities. This encourages owners to transfer ownership of their companies to employees upon retirement.

Another employee benefit that's based on speading company equity is the employee stock purchase plan. Read Employee Stock Ownsership Plans vs. Employee Stock Purchase Plans for an elucidation of the differences between the two arrangements.

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