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Employee Stock Ownership Plans (ESOPs)

An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that invests primarily in employer securities. ESOPs allow employees to share in ownership of their employer. Eligible employees are provided stock ownership as a benefit of working for the company. There are many benefits to providing an ESOP to employees, including the ability to maintain a certain corporate culture and provide employer-funded retirement benefits.

Regulation of ESOPs falls under the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC). ERISA is a federal law that establishes the minimum standards for most voluntary private pension and health plans. ERISA mandates fiduciary duties for plan managers and those who control plan assets, including requiring disclosure of plan information. ERISA also allows participants to file legal claims for benefits and breaches of fiduciary duty. The IRC establishes federal income tax rules for benefits and plan design.

An ESOP is a defined contribution employee benefit plan, with benefits based on how much stock the employee accumulates in their ESOP account over the course of their employment and how the company stock has performed. Shares may be allocated based on different formulas, but most commonly as a percentage of the employee's salary.

According to the National Center for Employee Ownership (NCEO), the average ESOP contribution is about 6-10 percent of employee pay. There are now more than 7,000 companies with ESOPs, with over 13 million employees participating in employee stock ownership plans. ESOPs are most common in privately held (non-publicly traded) companies.

ESOP stock acquisitions are usually funded through a loan taken out by the company. The company then loans the money to an ESOP trust. Alternatively, the seller may take back a promissory note and is paid for its shares in installments. The company makes contributions to the trust and the trust uses that money to repay the loan. Shares in the company are allocated to employees' accounts as the loan is repaid. When an employee leaves the company or retires, the company or the ESOP distributes the value of the employee's vested shares, usually in cash.

The price at which an ESOP purchases stock in the company is based on the stock's independently appraised fair market value. The value of a participant's interest is determined by an independent appraisal of the stock, valued at least once per year.

In most cases, the company funds the ESOP, with employees paying nothing to participate in the company's ESOP. However, some companies may have other programs which offer employees stock in the company. This includes direct purchase plans and stock options.

For contributions made in a plan after December 31, 2006, contributions in plans must vest under a three-year cliff or 6-year graded schedule. Under the 3-year vesting schedule, after three years, 100% of contributions are vested. Under the stepped schedule, after 2 years, 20% of the contributions are vested, with 20% more vesting each year. After 6 years, 100% of the contributions become vested. Vesting can be based upon a more rapid schedule based upon the design of the plan.

Benefits of an ESOP

One of the benefits of an ESOP is the understanding that employees who have an ownership interest in the company will be encouraged to do what is best for the company's financial interest. As shareholders in the company through participation in the ESOP, the employee has a financial incentive to see the company succeed. This may increase productivity, reduce waste, and increase profitability.

Tax incentives are another primary financial benefit to having an ESOP. Tax incentives may benefit the employee as well as the employer and founders of the company. Employer contributions to an ESOP are tax-deductible, generally up to 25% of employee payroll per year. The employer may also be able to deduct dividends paid on ESOP stock in cash to plan participants, dividends paid to the ESOP, or as dividends reinvested in company securities. Companies can also use an ESOP to borrow money and repay the debt with pretax dollars.

Employees enrolled in an ESOP are not taxed on the stock they are allocated under the plan until they receive distributions. The employee may also be able to rollover ESOP distributions into an IRA and defer paying taxes on the money until it is withdrawn.

Despite the many benefits of an ESOP, there may be some limitations. Some companies may not be able to take advantage of an ESOP, such as professional corporations or partnerships and LLCs.

ESOP Fiduciaries

Like with other retirement plans, an ESOP fiduciary owes plan participants the duty to act in their best interests. The same standards apply to ESOP fiduciaries as other ERISA fiduciaries, except an ESOP fiduciary may have no duty to diversify investments. Instead, ESOPs are required to primarily invest in employer stock. However, if the ESOP fiduciary fails to fulfill their legal obligations, they may be liable to plan participants for damages.

ESOP Litigation

When plan fiduciaries breach their duty to employees participating in the ESOP, the participants may have a cause of action against the fiduciary. The employees may believe the fiduciary was paying too much for company stock, based on a theory that the stock was overvalued, or the fiduciary was engaged in transactions that were not in the best interest of the ESOP participants. In other cases, the government may allege ESOP activities have violated ERISA or other federal restrictions on ESOP management.

While uncommon, some ESOP litigation may lead to a class action lawsuit. Some ESOPs may involve hundreds or even thousands of workers. A class action lawsuit generally involves a group of similarly situated plaintiffs. To be certified as a class action lawsuit, the class of people represented should be numerous, with claims involving common questions of law and fact, the claims of the named plaintiffs should be typical of others in the class, and the named plaintiffs should adequately represent the interests of the entire class.

For more information about our ERISA Litigation practice, please click here.

San Diego ESOP Attorneys

Butterfield Schechter LLP is San Diego County's largest firm focusing its law practice primarily on employee benefit legal services. We represent ESOP clients across the United States in all aspects of ESOP transactions. We are dedicated to employee ownership, as evidenced by our active involvement and leadership in such professional associations as The ESOP Association, the National Center for Employee Ownership (NCEO), and the Beyster Institute for Entrepreneurial Employee Ownership.

When you come to us for ESOP services, you receive influential legal counsel who stand beside you to help you stay informed, in compliance, and abreast of the latest developments—all to help you operate your plan to meet your goals for implementing the ESOP as fully and effectively as possible. Contact our office today with any questions on how we can help you and your business take advantage of the many benefits an ESOP program may offer.


1. Will I lose control of my company?

Adoption of an ESOP does not normally result in a change in management. Your company's Board of Directors selects the trustee, who generally retains the right to vote private company shares held in an ESOP.

Plan participants vote the shares allocated to their accounts only on a proposed merger, sale of the business, recapitalization or liquidation.

The trustee you select votes the shares on all routine corporate matters, such as Board of Directors' elections.

2. How do you determine the value of stock held in an ESOP?

The stock's price when purchased by your ESOP trustee, or the tax-deductible amount your corporation claims as an employer in connection with its stock contribution to the ESOP, must not exceed the stock's value, as determined by an independent professional appraiser who must utilize an appropriate appraisal methodology.

Stock is valued at least annually, and participants are informed annually of the value of shares allocated to their accounts.

3. Can I limit plan participation to key executives?

No. As a tax-qualified plan, ESOP participation must be available to a broad cross-section of employees who meet statutory standards, not just to a select group of key executives. However, union employees may be excluded if retirement benefits are the subject of good-faith negotiations with the union.

ESOP benefits cannot unduly favor officers, shareholders, or highly compensated employees--however, you may allocate benefits in proportion to the relative compensation of participating employees, and you may take their years of service into account for vesting of benefits.

4. May an existing pension plan or a profit sharing plan be converted into an ESOP?

Any qualified plan may be converted into or replaced with an ESOP, although different procedures apply to different types of plans.

In the case of converting an existing qualified plan to an ESOP, it is not generally advisable to use the funds of the prior plan to purchase or acquire securities of your company for the ESOP without obtaining the consent of the participants. In some cases, it may be prohibitively expensive to let participants decide whether or not to invest existing funds in securities of your company due to the requirement of complying with federal and state securities laws.

5. What are the typical sources of ESOP financing?

Sources of ESOP financing generally include regional commercial banks, insurance companies, credit and finance companies, and private investors. Your existing lending relationship may also be a potential source for ESOP financing. An experienced ESOP legal advisor has knowledge of ESOP lending sources and can identify and negotiate appropriate loan terms.

Most lenders see the ESOP and the sponsor-corporation as better credit risks because repayment of the loan principal can be made with tax deductible dollars, giving the borrower a significant advantage over most other companies who borrow funds.

6. What limits apply to an ESOP's ability to borrow money to purchase employer securities?

No requirements specifically limit an ESOP's ability to borrow, but practical constraints on the company's ability to make deductible ESOP contributions sufficient to repay ESOP debt control the amount an ESOP may borrow. The law limits annual deductible employer contributions used to repay an ESOP loan to interest on the loan, plus 25 percent of the total compensation of all employees participating in the ESOP.

The Internal Revenue Code also permits ESOPs of C corporations to repay acquisition debt with dividends paid on stock held by the ESOP. Like company ESOP contributions, dividends paid on the ESOP stock are deductible by the company if they are used to repay acquisition debt, but they do not count towards the 25 percent of covered compensation limit described above. C corporations which do not have sufficient covered payroll to repay acquisition indebtedness may use deductible dividends as an additional source of debt repayment funds. Dividends on ESOP stock are also fully deductible if they are paid directly to or passed through the ESOP to the participants.

7. What happens when a participant terminates or retires?

Unless your corporate charter or bylaws restrict stock ownership to employees (a typical provision often added when an ESOP is implemented), a retiring or terminated participant may elect to take his or her benefits in company stock. Otherwise, benefits may be paid in cash.

If company stock is distributed, your company may retain the right of first refusal. Retired or terminated participants who receive company stock from your ESOP have the option to sell those shares back to your company at a fair valuation. The company then has at least five years to pay the purchase price.

8. How are benefits paid?

Distribution of benefits must commence within one year of a participant's normal retirement, disability, or death--or within five years after a separation from service for any other reason.

However, if your company stock was acquired with a loan, you may delay the distribution of benefits to a terminated employee until after the loan is repaid.

9. Can my company be an S corporation?

Yes, beginning in 1998, S corporations have been permitted to maintain ESOPs as a result of the Small Business Job Protection Act. S corporation ESOPs can offer unique and significant planning opportunities in the optimum situation. Special rules apply to S corporations--so careful analysis is needed as to whether an ESOP will meet Internal Revenue Code ownership diversification rules for S corporation ESOPs.

10. How do I get started?

Consult with an experienced ESOP legal advisor. ESOPs must comply with highly technical provisions of tax and employee benefits laws. ESOPs are complicated to design. A legal advisor familiar with such laws can save you time as well as money.

ESOP Resources

Blog Posts

ESOPs & Succession Planning

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[BLOG SERIES - 3 OF 6] ESOPs: A Solution for The Great Resignation - Is My Company Too Small for an ESOP?

[BLOG SERIES - 2 OF 6] ESOPs: A Solution for The Great Resignation - What are the Benefits of an ESOP?

[BLOG SERIES - 1 OF 6] ESOPs: A Solution for The Great Resignation - What is an ESOP?

2022 ESOP Legislation Update: History Made in Federal Government First Set Aside Program for Wholly Owned ESOP Contractors

Celebrating the Decade of the ESOP during October - Employee Ownership Month!

Reducing High Turnover in Trucking with ESOPs

Solve Your Shareholder Liquidity Problems With an ESOP!

ESOPs Included in Coronavirus Aid, Relief, and Economic Security Act ("CARES Act") for Economic Injury Disaster Loans (EIDLs) 

Ready to retire and sell your business? Have you considered an ESOP as a succession strategy?

Which Employee Ownership Model is Right for Your San Diego Business?

House Bill Proposes Incentives for ESOPs

Employee-Ownership in the Publishing Industry

Pro-ESOP Legislation Updates

Innovation and Employee Ownership

Will California Follow Colorado's Governor Action in Expanding Employee Ownership?

Owners Looking to Sell Their Business May Be Overlooking a Prime Buyer in an ESOP

Promoting ESOPs as Succession Option for Retiring Business Owners

Owners Rewarding Employees in California Specialty Food Industry

Best Practices for ESOP Trustee and ERISA Compliance

B Corp ESOPs Combine Employee Ownership and Social Purpose

How ESOPs Can Address Wealth Inequality

Untapped ESOPs - Blood, Sweat and Beer: Why ESOPs and Breweries Go Hand-in-Hand

Succession Planning Strategies for the Retiring Small Business Owner

ESOPs for California Grocery Stores

Employee Ownership Over the Years

Pro-ESOP Bill Introduced in California

Senators Introduce ESOP to Expand Employee Ownership

Benefits of an ESOP for Family-Owned Companies

Can ESOPs Benefit Disadvantaged Communities?

Survey Shows ESOP Workers Have Higher Retirement Savings

October is ESOP Month!

Employee Ownership and ESOPs: Why Small Business Owners Need to Pay Attention Now

The Many Forms of Employee Ownership: ESOPs, Co-Ops, Profit Sharing Plans, and Equity Compensation Plans

A Little Helping Hand: U.S. Congress and ESOP Support

2019 National Defense Authorization Act Update

Will You Be Able to Retire from Your Small Business?

Progress on Two ESOP Bills in Congress

Challenges to Fiduciary Indemnification Agreements in ESOPs

ESOPs for Sports Companies in San Diego

Employee-Ownership in Southern California's Specialty Food Industry

Why are Employee-Owned Companies So Much Better With Retention?

ESOPs in the Craft Beer Industry

Are ESOPs Right for California Breweries?

How Technology Companies Can Benefit from Employee Ownership

Why Engineering and Architecture Firms are Turning to ESOPs

The Benefits of Being an Employee Owned Company

ESOP Fiduciaries Liable for Overvalued Stock

Department of Labor ESOP Fiduciary Investigations

ESOP Pitfalls and How to Avoid Them

ESOPs: Latest Trends and Developments in the 2017 Landscape

ESOPs: Issues to Consider Before Converting from C-Corp to S-Corp

ESOPs Can Provide Liquidity to Facilitate Division of a Family-Owned Business Upon Divorce

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Succession Planning for Your Construction Business

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Documents & Publications

ESOPs, Family Businesses and Estate Planning

ESOP Document Design Checklist

ESOP Booklet

ESOP Organizations

NCEO is a nonprofit supporting the employee ownership community. Whether you are considering employee ownership, managing a plan, or advising clients, the NCEO can help you make smart decisions and connect with thousands of companies.

The Beyster Institute at UC San Diego's Rady School of Management works to advance the understanding and practice of employee ownership as an effective and responsible business model. We focus on education, research and consulting to promote employee ownership and the creation of effective ownership cultures.


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