An employee stock ownership plan is a retirement benefit that makes workers part owners of the company

• An employee stock ownership plan provides employees with shares of a company, which makes them part owners.
• Most ESOPs grant employees shares outright instead of requiring them to contribute to the plans.
• ESOPs help employees save for retirement while providing the company tax benefits and fostering overall growth.

If you're looking to work for a company that values employees and gives you a real stake in its success, you might want to check out those that offer an employee stock ownership plan (ESOP).

An ESOP is a retirement program that makes employees part owners of the company. The National Center for Employee Ownership (NCEO) estimates that more than 14 million people participate in 6,600 ESOPs nationwide. While some publicly traded companies offer ESOPs, the plans are more common among privately held employers. Here's a closer look at how ESOPs work and the advantages you could get by working for a company that provides this kind of benefit.

How does an ESOP work?

An ESOP is basically a trust fund a company establishes to purchase shares of stock from existing stockholders. Those shares are then allocated into accounts designated for individual employees, usually aligned with a percentage of their salary. The shares accumulate in the account until the employee retires, leaves the company, or some kind of special circumstance occurs, such as death or disability.

Employees usually don't put any money into an ESOP. In most cases, the employer makes all contributions.Workers cash out by selling shares on the market or back to the employer. ESOPs are regulated under the Employee Retirement Income Security Act (ERISA). Privately held ones must have company stock independently appraised for its fair market value at least once per year.

"The appraisal firm needs to use at least three methods to come up with a fair market value for the stock and the employees," says Loren Rodgers, executive director for NCEO. "When they leave [or] when they pull stock out of the ESOP, [the employee] needs to get at least that fair market value."

Quick tip: Rodgers says companies with ESOPs contribute an average of 9% of their payroll into the programs annually, while employer contributions to 401(k) plans are closer to 4%, meaning ESOPs could provide more "free" money toward your retirement goals.

Be careful not to confuse ESOPs with employee stock option plans, which give workers a chance to purchase shares in the company at a specified price within a fixed window of time, providing the chance to acquire them at a discount to the market price. Most ESOPs grant shares of stock to employees outright. In that case, if the value of those shares never rises, or even falls, the employee hasn't lost anything by participating. The same is not always true for stock options.

"With stock options, employees pay cash for the stock either directly with cash on hand or indirectly by exercising the option and immediately selling enough shares to cover the exercise price," explains Elliot Raff, Of Counsel at Keightley and Ashner LLP. "In an ESOP, employees 'buy' the stock allocated to their ESOP accounts by virtue of being and remaining employed and thereby becoming vested."

Finally, Raff says ESOPS are subject to non-discrimination rules under ERISA and Internal Revenue Service regulations about annual limits on the value of allocations. Stock option plans are not, allowing companies to set their own rules for who benefits from this kind of program and how it will work.

What are ESOP tax advantages?

ESOPs offer tax advantages for both employers and employees. Contributions to an ESOP are tax deductible, and if a shareholder sells their stock to the ESOP, they may be able to avoid or defer paying capital gains taxes.

"A selling shareholder may be able to defer capital gain on the sale to an ESOP," says Peter Jones, an attorney with Tucker Ellis LLP specializing in ESOPs. "That occurs if the company is taxed as a C corporation, the seller sells at least 30% of the outstanding stock to the ESOP, and the seller then invests in qualified replacement property (generally, securities offered by American-operating companies)."

If an S corporation has an ESOP, earnings attributable to shares in the plan are not taxable. "Profits that are attributable to stock held by the ESOP 'pass-through' to a qualified retirement plan, and the ESOP pays no federal income tax, and even no state income tax in most states," Jones says. "If the ESOP owns 100% of the stock, neither the company nor the ESOP pay any federal or, in most instances, state tax."

For employees, they get to invest in their retirement without paying taxes on the value of that money until they take distributions. To further delay paying taxes on ESOP earnings, they may also be able to sell their shares and roll over that money into an IRA or 401(k) account.

How do ESOP distributions and payouts work?

ESOP distributions work a little differently from other retirement plans and can vary from company to company. According to NCEO, some general rules that apply to most plans include:

• Distributions must begin the plan year following retirement age, death, or disability.
• If you quit or are fired from your job, you can begin receiving distributions no later than six years after the plan year during which you leave has ended.
• If the ESOP took out a loan to purchase shares you wish to collect on, distribution may be delayed until the loan is paid in full.
• Shares can be distributed in a lump sum or over time in "substantially equal payments that are made no less frequently over annually over a period of not more than five years."

ESOP participants may also be subject to vesting schedules. Rodgers explains that ESOPs have two options for vesting. The first is to grant 100% vesting once an employee completes three years of service, with none before then.The second is to grant 20% vesting every year starting in an employee's second year of service. ESOPs can choose any method to vest employees faster, but can't use a vesting schedule that would take longer.

Companies with ESOPs are required to repurchase stock when an employee retires or leaves the company. However, Rodgers says private companies are only required to do so for two years following an event that qualifies for distribution. Most people cash out in the first year because after the second, there's no guarantee someone will buy their shares.

If someone quits or is fired, they usually won't be able to cash out their ESOP shares right away. Federal law gives ESOPs as long as five years to distribute shares in these cases.

Note: A 2021 NCEO study found 56% of companies with ESOPs also offer additional retirement plans.

What are the pros and cons of ESOPs

ESOPs provide a lot of benefits both for employers and their workers. But they might not be right for some companies, and there are some limitations to accessing the money that employee participants should consider. Here is a look at some of the pros and cons of ESOPs.

The financial takeaway

ESOPs are generally beneficial for both companies and employees. They can foster a strong employee-owner culture that values training, education, innovation, and finding creative solutions. Working in this kind of environment can be very rewarding. Business owners can use an ESOP to establish a legacy for their company when they're ready to take a step back or even sell. The financial benefits for the business often outweigh the expenses, though ESOPs tend to work best for large companies

An ESOP can be a very strong component of a retirement strategy. However, it's important to remember that they are entirely focused on the stock of a single company. Diversification is key when it comes to long-term investment, so it's a good idea to look into additional options, such as IRAs or 401(k) accounts as part of your bigger retirement plan.