What Is an Employee Stock Ownership Plan (ESOP)?

Definition & Examples of an Employee Stock Ownership Plan

woman checking her employee stock ownership plan on her phone
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An employee stock ownership plan (ESOP) is an employee benefit offered to new and existing employees which gives them access to an allocation of company stock.

Learn more about how ESOPs work, as well as their advantages and disadvantages. 

What Is an Employee Stock Ownership Plan (ESOP)?

An employee stock ownership plan is a type of benefit plan that invests in company stock and distributes shares to its employees. It's a way of transferring company stock to employees without requiring selling the business to a third party. ESOPs also function as a type of retirement plan by providing income to employees through the sale of their stock when they retire.

Employee stock ownership plans are designed to increase employee investment in positive outcomes for the organization. After all, if an employee owns stock in the company, then they will likely feel motivated for the company to succeed and for the firm's stock value to increase. Employees who own stock in the company have an incentive to remain at the company, which could reduce employee turnover.

There are about 6,500 employee stock ownership plans in the United States covering an estimated 14 million employees. This is in addition to other forms of employee ownership, including direct purchase plans, stock options, and more.

How an Employee Stock Ownership Plan Works

In an employee stock ownership plan, the employer allocates a certain number of shares of the company to each eligible employee. The allocation of shares may be based on the pay scale or some other similar form of distribution. 

Each employee’s shares are held in the company’s ESOP trust until the employee leaves or retires. At that point, employees can sell the shares, either on the open market or back to the company. Employees are not taxed until they sell their shares. Under certain circumstances, taxes can be deferred even further if proceeds are reinvested in the stocks of other companies. 

ESOPs generally are subject to rules regarding participation, vesting, and allocation.

Typically, employees are not eligible to participate in a company's stock ownership plan until they have worked a certain number of hours or years. And, employees generally need to be vested, meaning they have a claim to those benefits, before being able to access the funds.

Advantages and Disadvantages of Employee Stock Ownership Plans

Advantages
  • Fosters ownership mentality

  • Linked to positive employee outcomes

  • Tax benefits

Disadvantages
  • Diversification risk

  • Performance risk

  • Limited availability

Advantages Explained

  • Foster ownership mentality: Employee stock ownership plans encourage employees to take ownership of the company's success.
  •  Linked to positive employee outcomes: Research shows employees are less likely to be laid off or experience employee turnover at companies with employee stock ownership plans.
  • Tax benefits: Employees are not taxed on their shares until they sell.

Disadvantages Explained

  • Diversification risk: Employees who use ESOPs as their main or exclusive form of savings are taking a risk by not diversifying their portfolio.
  • Performance risk: If the company has setbacks or performs poorly, employees may find themselves losing equity as well as potentially being laid off.
  • Limited availability: Employee stock ownership plans are only available for S-corporations and C-corporations.

Are Employee Stock Ownership Plans Worth It?

For job candidates who are interviewing at a company with an employee stock ownership plan, or who received a job offer from one, it's important to consider the implications. As with any benefit, you should consider this as well as salary when reviewing the offer or considering if the company is the right fit for you. 

If the company does not offer additional retirement benefits, such as a 401(k) plan, for instance, and you are concerned with the company's overall health, an ESOP may not be a great benefit, because of the risk you take if the company's performance goes south.

If you get a job offer, ask your contact in the human resource department for details on the ESOP, so you know precisely how it works. Also ask about other retirement plan options that the company may offer. Three key considerations to keep in mind are the value of the stock, how benefits are paid out, and the way that the ESOP will be taxed. 

Key Takeaways

  • An employee stock ownership plan is a benefit plan that gives employees access to shares of company stock.
  • It can be used as a form of retirement plan, since the shares can be sold for income when the employee retires.
  • Employees aren't taxed on their shares inside the ESOP until they're sold.
  • Companies with ESOPs are often linked to positive employee outcomes such as lower turnover.

Article Sources

  1. National Center for Employee Ownership. "What Is Employee Ownership?" Accessed Sept. 18, 2020.

  2. IRS.gov. "Employee Stock Ownership Plans Determination Letter Application Review Process." Accessed Sept. 18, 2020.

  3. National Center for Employee Ownership. "New Data on Employee Ownership from the General Social Survey." Accessed Sept. 18, 2020.