To increase the number of ESOPs, Congress created them with significant tax benefits for the company, selling owners, and employees. ESOPs are regulated under the Employee Retirement and Income Security Act (ERISA), and are therefore somewhat similar to a 401(k) plan, with the significant distinction that ESOPs are required to invest primarily in company stock. There are currently over 8,926 companies with ESOPs or equivalent plans in the United States employing 14.7 million people.
How does an ESOP work?
An ESOP is a defined contribution retirement plan that holds company stock in a trust for the benefit of employees. Because ESOPs were intended to encourage broad-based employee ownership, they have minimum participation requirements-in general all full time employees who are age 21 or over participate in the plan.
ESOPs are almost always funded by the employer. Similar to 401(k) matching, contributions to the ESOP are a tax-deductible compensation expense. The company allocates stock to individual employee accounts based on a non-discriminatory formula, most commonly determined by salary. Employees receive the vested portion of their account balance when they retire or leave the company, most commonly in the form of cash based on the most current valuation of company stock.
Although the stock is held for the benefit of employees, employee-owners are not required to have full shareholder rights. However, the plan must provide employees with minimum rights which allow them to vote on issues of merger, acquisition, divestiture, recapitalization or a sale of substantially all of the assets of the corporation.
How are ESOPs used?
ESOPs are a significant retirement benefit for employees and a powerful tool for employee engagement. Employees often receive hundreds of thousands of dollars in addition to their 401(k) accounts and other retirement funds. In addition, many companies with ESOPs practice participatory management to encourage employees to "think and act like owners." According to numerous research studies, companies that combine the ESOP with an ownership culture generally outperform their competitors and grow faster than they would have otherwise been expected to.
In addition, ESOPs are a unique type of plan that can also be used as (1) a flexible, tax-advantaged tool for business succession, (2) a way for the company to borrow money and finance projects, and (3) a way to create an internal market for company stock. This article has more information about how ESOPs can be used in these ways. The article also discusses common feasibility questions that can help determine whether an ESOP would make sense at your company.