Employee Stock Ownership Plan (ESOP): A Powerful Way To Motivate Your Employees

An employee stock ownership (ESOP) is an employee benefit program that grants workers ownership in the company through shares of stock. 


The sponsoring company and participants receive tax benefits. ESOPs are considered qualified plans. Employers often use ESOPs to align their employees’ interests with their shareholders.


To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.



  • Employee stock ownership plans (ESOP) are an employee benefit plan allowing workers to own stock shares.
  • ESOPs encourage employees and motivate them to give all they have for the company’s success.
  • They can also make staff feel appreciated and more compensated for their work.
  • Companies often tie distributions from the plan with vesting. This gives employees rights over time to employer-provided assets.
  • It is essential to carefully read your ESOP terms, as they may differ and have different rules.
  • Other forms of employee ownership exist in stock options, stock options, and restricted stock. Phantom stock is also available. Stock appreciation rights can also be used.

Employee Stock Ownership Plan (ESOP) 101

A benefit plan called an employee stock ownership plan (ESOP) gives employees a stake in the business by giving them stock. There are two ways employees can get ownership: directly purchasing shares or by being given stock from the company.


Employee Stock Option Plans offer employees a way to save money for retirement savings that is not limited by traditional bonds and stocks. ESOP plans enable employees to invest directly in the company they work for and then gain potential gains on company stock once they turn 59 1/2. While some employees may be able to realize their gains sooner, most employee stock option plan participants can cash out their earnings during retirement.


What is an Employee Stock Ownership Plan?

An employee stock option plan allows employees to purchase shares of corporate stock to help with succession planning.


ESOPs can be funded through a variety of methods. Companies can put new shares in them, borrow money through the entity, or cash in to purchase existing company shares. Companies of all sizes can use ESOPs, including large publicly traded corporations.


Contrary to popular belief, companies that have an employee stock option plan are not allowed to discriminate. They must appoint a trustee who will act as the plan fiduciary. It is impossible for senior employees to get more shares, or for ESOP participants not to have voting rights.


Advantages of ESOPs

ESOP shares can be used by companies to keep plan participants’ attention on share price appreciation and corporate performance. These plans are said to encourage plan participants to make the best decisions for shareholders by giving them an incentive to see the stock perform well.


The company offers employees the opportunity to earn more, get rewarded for their dedication, and increase their pay. Employees should feel valued and more excited about going to work.


Uses of ESOPs

  1. To purchase the shares of a departing owners: Privately held company owners can use an employee stock option plan in order to create a market for their shares. This allows the company to make tax-deductible cash contributions or borrow money from the ESOP to purchase the shares.

  2. To borrow money at lower after-tax costs: ESOPs offer a unique benefit plan in that they can borrow money. The ESOP borrows money to purchase shares in the company or share of existing owners. To repay the loan, the company makes tax-deductible contributions. Principal and interest are both deductible.

  3. To provide an additional benefit for employees: Companies can simply issue new shares or treasury stock to an ESOP and deduct their value (for as much as 25% of covered pay), from taxable income. A company can also contribute cash by buying shares from private or public owners. ESOPs are commonly used with employee savings plans in public companies. They account for around 5% of all plans and 40% of plan participants. Instead of matching employee savings with cash the company will match them up with stock from an employee stock option plan. This is often at a higher level.



Major tax benefits

ESOPs offer a variety of tax benefits that are significant, including the following:


  1. Stock contributions are tax-deductible. This means that companies can gain a cash flow advantage by issuing new shares, treasury shares or ESOP shares. Existing owners will be diluted.

  2. Cash contributions can be deducted: Companies can make discretionary cash contributions year-round and claim a tax deduction. Contributions can be used to purchase shares from current owners, or to build up a cash reserve for the ESOP.

  3. Contributions to the repayment of a loan that the ESOP takes to purchase company shares are tax-deductible. The ESOP has the option to borrow money to purchase existing shares, new shares or treasury stocks. The contributions, regardless of their use, are deductible. This means that ESOP financing occurs in pretax dollars.

  4. C-corporation sellers can receive a tax deferral. Once the ESOP has 30% of all shares, a C-corporation seller can reinvest the profit sharing plan in other securities to defer any pay tax.

  5. The ESOP’s ownership percentage in S corporations is exempt from income tax at both the federal and state levels.This means that 30% of profits of S corporations with an ESOP owning 30% of stock are exempted from income tax, while 30% is exempted from income tax for S-corps wholly owned by their ESOP. The ESOP must still receive a pro-rata portion of all distributions made by the company to owners.

  6. Dividends can be tax-deductible. Reasonable dividends that are used to repay an ESOP Loan, passed on to employees or reinvested by employees into company stock, are tax-deductible.

  7. Employers pay no tax on contributions to the ESOP. Only the distributions of their accounts are subject to tax at potentially favorable rates. Employees can rollover their distributions into an IRA or another retirement plan. Capital gains accumulated over the years will be taxed as capital gain. If the distributions are made before the normal retirement age, income tax will be subject to a 10% penalty.

It is important to note that contribution limits can be subject to some limitations. However, these are rarely a problem for companies.




These tax benefits may seem attractive, but there are limitations and drawbacks. ESOPs cannot be used in partnership or professional corporations according to the law.


Corporations can use ESOPs, but they are not eligible for the rollover treatment described above and have lower contribution limits. Private companies are required to repurchase shares from departing employees.


This can be a significant expense. An ESOP can also be expensive. It costs around $40,000 to set up the simplest plan in small businesses and then on up. Stock of existing owners gets diluted every time new shares are issued.


This dilution must be weighed against any tax- and motivational benefits that an ESOP could provide. Lastly, ESOPs can only improve corporate performance if they are combined with the opportunity for employees to take part in decisions that affect their work.


ESOP up-front costs and distributions

Many companies offer employees ownership without any upfront costs. The shares may be held in trust by the company until the employee resigns or retires.


Companies often tie distributions from the plan with vesting which grants employees rights to employer assets over time. Typically, employees earn a greater share for each year they serve.


The firm “purchases back” the shares from fully-vested employees when they retire or resign from the company. The employee receives either a lump sum or equal periodic payment, depending on which plan they have.


The shares are resold or nullified by the company after the employee has been paid and the shares have been purchased by the company. The shares of stock cannot be taken with employees who quit the company. They can only receive the cash payment.


How to cash out of an ESOP

You can’t cash out of an ESOP if you are vested. These shares can only be redeemed if you are terminated from employment, retired, die or become disabled.


It is important to consider your age. Distributions to individuals under the age of 59 1/2 (or 55 if terminated) are not allowed. If they are permitted, they may be subject to a 10% penalty for early withdrawal. The plan guidelines contain detailed information on how to cash out an ESOP.


ESOP and other forms of employee ownership

Stock ownership plans offer additional benefits for employees and reflect the corporate culture that managements desire to preserve.


Stock options, stock options, limited stock and phantom stock are all other forms of employee ownership.


  • Employees can purchase shares of companies using their personal after-tax money. Some countries offer tax-qualified plans that allow employees to purchase stock of companies at discounted prices.

  • Limited stock allows employees to be granted shares as gifts or as purchased items after they have met certain restrictions such as working for a specified period or meeting specific performance targets.

  • Stock options give employees the chance to purchase shares at a fixed price and for a specific period.

  • Phantom stock offers cash incentives to employees who perform well. These bonuses are based on the number of shares.

  • Employees have the right to increase the value of a specified number of shares. Stock appreciation rights allow employees to do this. These shares are usually paid in cash by companies.


What is an ESOP example?

Imagine an employee who has been working at a large technology company for five years. The company’s ESOP gives employees the right to 20 shares in the first year and 100 after five years.


The share value will be paid in cash when the employee dies. Stock options, stock appreciation rights and restricted shares are all possible stock ownership plans.


Are ESOPs good for employees?

Yes, ESOPs are generally considered a benefit to workers.


Companies that do not frequently change their staff tend to adopt these programs. They often pay a higher payout and offer greater financial compensation to employees.


Bottom line

Employers and employees generally find ESOPs a win-win situation. They encourage greater effort and commitment, in return for higher financial rewards. They can be confusing and frustrating for participants who don’t understand the details of the plan.


There are many ESOPs. You should be aware that there are different rules regarding vesting and withdrawals. This will allow you to maximize your benefit and avoid missing out on any potential bonus.


To learn more about other terms commonly used in venture capital, check out our complete VC Glossary.


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