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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What alternatives are there to basing ESOP allocations on relative compensation?

There are several alternative allocation approaches. In the most general terms, all ESOPs must meet the basic test that no highly compensated person receives more than would be allocated under a relative pay basis. Because basing allocations on relative pay is a safe harbor that does not require testing, alternative allocation formulas should be discussed carefully with legal counsel to make sure they meet the rules. The test for any alternative pay formula is that highly compensated employees (a legal term that for these purposes is $160,000 in 2026, indexed annually for inflation) cannot get more under the alternative formula than they would under a relative pay formula. If they do, then the excess must be reallocated to other participants.

It might seem that other formulas, such as giving one point for seniority and one for pay, would push distributions downward and therefore would more easily pass the test for being nondiscriminatory, but the situation is a little more complex. If the effect of the formula is that just one highly compensated person gets more than would be allocated under straight pay, the whole formula is disqualified. In this example, you could have a highly paid, very senior person who would do better under this approach than a straight pay formula. As noted, however, a plan can be designed, however, with a fail safe provision so that in any potential violation, the formula would revert to straight pay for those who would cause the violation.

Here are some alternative approaches:

1. Per capita: Everyone gets the same. The big disadvantage here is that it caps the allocation at the pay of the lowest paid participant (because no one can get more than this person). This can be a major problem in leveraged plans because it excludes a lot of the payroll base from allocations, meaning less can be paid on the loan. For instance, if total pay is $3 million for 50 employees (an average of $60,000 per employee), but pay ranges from $40,000 to $400,000, an equal allocation formula would only make $2 million of payroll eligible (50 x $40,000, the pay of the lowest paid person). So the maximum annual contribution would be 25% of $3 million, not $1 million.

2. Points for seniority: Some companies allocate based on a percentage for pay and a percentage for seniority. This tends to push allocation downward, but in some cases can result in too much going to higher paid people. One easy solution is to put a rule in the plan that allocation is capped at what would be allocated on straight pay or at some dollar compensation limit. Any excess gets reallocated.

3. Capping eligible pay: Federal law limits individual eligible pay for allocation purposes to $360,000 (this number is in 2026 dollars and is indexed annually); a company could choose to push this down even further. This can cause the same problem as in the first formula. Note, of course, that this is not an issue if the amount of the loan does not require contributions near the Section 415 limits (the limits on maximum allocations).

4. Relating allocations to employee sacrifices: Where employees make wage concessions, allocations are often based on the percentage of wages they give up. To the extent these are not based on the same percentage of pay for everyone (as is often true), this formula will differ from straight pay allocations. Again, this can limit total eligible payroll.

5. Basing allocation on 401(k) contributions: Plans that combine an ESOP and a 401(k) can base the ESOP allocations on employee 401(k) contributions. The ESOP contributions become the 401(k) match. This can result in a very different allocation formula than under an ESOP, but the complex testing rules basically follow 401(k) rules. Thus, if the plan qualifies for 401(k) rules, as long as the ESOP match is the same percentage for everyone (e.g., 50 cents on the dollar), the ESOP allocation qualifies. This is often used in very large companies, but relatively rarely in private company ESOPs.

For more information, See Understanding ESOPs.

Link to this FAQ Topic: ESOP Plan Design & Participation