Frequently Asked Questions

Employee Ownership FAQs

Common questions about employee stock ownership plans (ESOPs), employee ownership trusts (EOTs), and other forms of employee ownership, from the basics to technical topics.

This FAQ is written primarily for business owners, managers, and advisors involved in setting up or running an employee ownership plan. If you're an employee at an ESOP company looking to understand your own benefits and rights, see our articles on Working at an ESOP Company and The Rights of ESOP Participants.

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Can funds from a defined benefit plan be used to fund an ESOP?

Using defined benefit plan assets to fund an ESOP is possible, but complex and limited. Defined benefit plans (what most people think of as "pension plans") promise a specific annual benefit at retirement. Companies fund these plans for employees based on actuarial assumptions about their work force and financial assumptions about how well the pension fund assets will perform.

The only way to move assets from a defined benefit plan into a defined contribution plan (such as an ESOP) is to terminate the defined benefit plan. At that point, all participants must be fully vested, and they must receive their benefits. Normally, this is done by the employer purchasing annuity contracts (a form of insurance providing employees with whatever their accrued benefit would equal in the form of payments to start at normal retirement age). If annuity contracts are not purchased, the benefit must be paid out as specified by the plan.

If, after all these benefits are fully paid, there is additional money in the fund, this excess can revert to the employer or to a replacement plan. If the employer keeps the money, it is taxable as income, plus there is a 50% excise tax. If it is rolled into a qualified replacement plan, of which the ESOP is one, it is still taxable as income, but the excise tax is only 20%. Amounts of 25% or more of the converted assets that go into the ESOP, however, would not be subject to this 20% tax or the 50% tax. Amounts in the ESOP would then be allocated according to the plan's formula. If there is more than can be allocated in any year due to annual contribution limits, the excess goes into a reversion suspense account and continues to be allocated until no funds are left.

A defined benefit plan's excess assets cannot be reverted in the first five years of the pension plan's operations.

In theory, it is also possible to convert a defined benefit plan into an ESOP. The defined benefit plan would be terminated and all participants would have to be able to choose whether to receive the full value of their distributions or have them rolled into the ESOP. Because this is a securities election, it is subject to all securities laws. No transactions have ever been done this way.

Because of all these restrictions, reversions from defined benefit plans into ESOPs have not been done since the 1990s.

Link to this FAQ Topic: Financing an ESOP