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An employee stock ownership plan, or ESOP, is an employee benefit plan that gives workers shares in the company they work for. Employees receive the value of those shares when they retire or leave the company.
There are thousands of ESOPs in the U.S., according to the National Center for Employee Ownership, which maintains a database using company documents filed with the Department of Labor[0].
ESOPs span industries, such as manufacturing, science, technology, finance, insurance and real estate. Many of the largest employee-owned companies are supermarkets, construction companies, architecture and engineering firms, manufacturers and health providers.
How does an ESOP work?
Here are the basic functions of an ESOP.
The company forms an ESOP trust, which is a legal entity that will hold shares until they are contributed to individual employee accounts.
The company funds the trust with new shares of the company or cash that is used to purchase shares from the company’s owners. An ESOP trust also can borrow money to purchase the company stock (in that scenario, the company then makes tax-deductible contributions to the trust to pay off the loan).
The trust gives shares of the company to employees. Generally, employees who have at least one year at the company receive shares from the trust based on their tenure, and those shares vest over time. That means it can take years for an employee to gain full rights to the shares they’ve received. Workers typically don’t pay taxes on their shares until they leave the company.
The company buys back shares from former employees. When an employee with vested shares leaves the company, the company typically buys back the stock, giving the worker cash for the value of the shares. Payouts can be delayed, though, depending on the plan’s design[0]
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Why companies have ESOPs
There are three common reasons companies have ESOPs.
1. Transferring ownership
ESOPs are most commonly used to help private company owners sell their stake in the business. To do this, the ESOP trust purchases shares at fair market value from one or more of the owners of the company, allowing that owner to leave the company without selling the business to an outside buyer. This can have its downsides because even though the ESOP pays fair market value for the shares, a third-party buyer might be willing to pay more. However, closely held companies, such as a family business, may opt to sell the company to its employees (via the ESOP) as a way of protecting it from outside buyers.
2. Employee benefits
An ESOP can be an employee retirement benefit, similar to a 401(k) or other employee equity plan.
ESOPs can give employees ownership in the company, which helps align workers’ interests with company success. Employees’ shares may become more valuable if the company’s value increases.
For employees, an advantage of an ESOP is that they get shares without making any out-of-pocket contributions. But unlike other types of employee equity plans, such as restricted stock units (RSUs), workers participating in an ESOP can’t access the value of their shares until they retire or leave the company.
As a retirement plan, ESOPs differ from other employee stock ownership plans in at least one key way. Distributions may face tax penalties if they’re taken before age 59 ½ (though there are some exceptions)[0]. That may influence what you do with your shares — or the value of those shares — after leaving your job.
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Employee equity programs can be complex. A financial advisor could help if you’re wondering what to do with an ESOP or another type of employee stock ownership plan.
3. Borrowing money
A company may create an ESOP if it’s looking for a less expensive way to borrow money. The trust can borrow money from a bank or other lender and then use it to buy newly issued stock from the company. The company then makes tax-deductible contributions to the ESOP, which uses the money to pay off the loan[0].
Pros and cons of ESOPs
There are advantages and drawbacks to ESOPs for employees at companies that offer them. But keep in mind that each ESOP is governed by its own rules.
Employees receive shares without any out-of-pocket costs.
Typically have a years-long vesting schedule.
May be offered in addition to other retirement benefits such as a 401(k).
Workers typically can’t access the value of their shares until after leaving the company. There may be tax penalties for early distributions.
Participants have some voting rights as shareholders.
May have provisions that delay buying back an employee’s shares after the employee has retired or left the company.
What happens to my ESOP when I quit?
If you quit your job, what happens to your ESOP account depends first on how vested you are.
If you’re partially or fully vested, you’re typically entitled to whatever portion of the account you’re vested in. Generally, the payout can be in cash or shares, with the option to sell the shares back to the company at fair market value. When the payout occurs — and what form it’s in, whether cash or shares — depends on the plan’s design. ESOPs can delay payouts by up to six years when you quit your job.
If you’re not yet vested in your account (and you haven’t reached your plan’s retirement age), you might lose all rights to your ESOP if you leave the company.
To know if you’re vested in your ESOP, you’ll need to know the vesting schedule your plan uses.
ESOPs commonly follow schedules that either vest gradually (so you earn a right to, say, 20% of the account per year for five years) or all at once (so you earn a right to 100% of the account after completing a certain number of years of service).
If all or part of your account is vested and you quit before age 59 1/2, you may be able to roll it into your next employer’s retirement plan or into an IRA to avoid paying a tax penalty on an early withdrawal[0].
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