What is an employee stock ownership plan (ESOP)?
July 20, 2023 8 min read
An employee stock ownership plan (ESOP) is a type of retirement plan that allows companies to transfer ownership of the company to employees. According to the National Center for Employee Ownership, a nonprofit that promotes employee ownership, there are about 6,500 ESOPs in place in 2023. And the plans cover nearly 14 million participants.
Find out more about how ESOPs work, their potential benefits and drawbacks, and the answers to some frequently asked questions about ESOPs.
- Employee stock ownership plans (ESOPs) are a type of retirement plan that allows a company—most often a privately held company—to give shares of the business to its employees.
- Unlike many other types of retirement accounts, employees generally don’t contribute to an ESOP. Instead, the company fully funds the benefit.
- Becoming a partial owner of the company you work for can be financially and personally rewarding. But if an ESOP is your only retirement account, having all of your income and retirement savings tied to a single company may carry some risk.
What is an employee stock ownership plan (ESOP)?
An ESOP is a tax-advantaged retirement plan that allows workers to earn shares in the company they work for as an employee benefit.
The majority of ESOPs are in privately held companies rather than public ones. A company’s owners may create an ESOP when they’re ready to retire or sell the business as a way to borrow money or as an employee benefit and incentive.
Unlike other types of retirement accounts, employees generally don’t contribute to an ESOP. The company will fully fund the benefit. Employees also don’t have to pay taxes on the contributions, although they may pay taxes on distributions later—similar to a tax-deferred retirement account, such as a 401(k).
Some companies create an ESOP in combination with a 401(k), giving employees multiple sources of potential retirement income. Employees can contribute to their 401(k), and the company may match a portion of employees’ 401(k) contributions by paying into the ESOP.
How does an ESOP work?
Companies set up the ESOP as a trust fund, a legal entity that’s separate from the business. The company then gives shares or money to buy shares to the ESOP. Or the ESOP borrows money to buy shares from the company, which is known as a leveraged ESOP. The ESOP then holds on to the shares on behalf of the employees.
Depending on how an ESOP is arranged, ownership may depend on things like pay or tenure. There’s often a vesting schedule, meaning membership in the ESOP is tied to how long a person has worked at the company. For example, a person may need to work at the company for three to six years before unlocking full ESOP benefits.
When ESOP owners leave a company or retire, they may be able to convert their portion of the ESOP into shares in the company stock, cash or a combination of the two. As with other types of retirement accounts, there may be taxes on distributions for people under 59½ years old or for people under 55 who are forced to leave their job. Rolling the distributions into an IRA or another retirement account could be another option.
What is an ESOP trustee?
An ESOP trustee manages and controls the ESOP and has a fiduciary duty to the plan’s participants—the employees. It’s an important role. The person or group may be responsible for things like conducting annual appraisals and deciding the value of shares based on the appraisal.
The share cost determines how much the ESOP will pay the company’s owners for their shares—and how much the company will pay employees who receive distributions and want to sell shares back to the company when they retire or leave.
Benefits and drawbacks of an ESOP
As an employee, you could benefit from your employer’s ESOP by
- having an employer-funded retirement benefit with tax advantages.
- getting to own a piece of the company you help run.
Business owners can also benefit from an ESOP in various ways. Having more engaged and motivated employees is one benefit. Business owners who are ready to sell the business and are having trouble finding a buyer may be able to sell their shares to the ESOP instead.
Additionally, the company could use the sale of shares to raise money for business expenses, and its contributions to an ESOP may be tax-deductible.
If an ESOP is your only retirement account, having your income and retirement savings tied to the success of a single company may carry some risk. So if the ESOP alone isn’t enough to cover retirement expenses, it may be worth considering other retirement accounts too.
How are ESOP shares allocated?
The amount an ESOP member receives could depend on how long they’ve worked for the company, how much they earn or a combination of the two. But some companies equally allocate shares among eligible employees. To qualify, you may have to be at least 21 years old and a full-time employee.
Companies also have to adhere to IRS regulations when creating a formula for determining how many shares employees receive. You can ask the HR department, or whoever is in charge of employee benefits, how the ESOP works at your company if you have specific questions.
Have more questions about how an ESOP works? Check out the answers to these frequently asked questions below.
Which companies offer ESOPs?
There are a variety of small and large businesses that offer ESOPs to their employees. Some well-known companies include Publix Super Markets, Bob’s Red Mill and WinCo Foods.
What’s the difference between an ESOP and a 401(k)?
ESOPs and 401(k)s are both tax-advantaged retirement accounts that come from your employer. You may have the option to participate in both.
But there are some important differences between the two. With an ESOP, only your employer may give you company shares that are held in a trust. With a 401(k), both you and your employer can contribute to an account, and you can then use the money to invest in a range of preselected investment options.
How much is your ESOP worth?
The value of your ESOP will depend on how many shares you earn and how much each share is worth. ESOP participants should receive an annual statement with the current value. But the value may change as the share price moves up or down.
ESOPs in a nutshell
An ESOP is a way for a company to transfer ownership to its employees, which can be a way to give the company and its employees an additional benefit for keeping the company running.
The number of shares you receive is often tied to your tenure or pay—which is one of many reasons you should know how to negotiate your salary.
Looking for more information on employee benefits? Check out this guide to employee fringe benefits.