How an Employee Stock Ownership Plan (ESOP) Works

An employee stock ownership plan (ESOP) is an employer-sponsored benefit plan that gives employees an ownership stake in the business where they work. Companies use ESOPs as a tax-advantaged way to share ownership broadly with employees. As of the most recent data, 6,411 ESOP companies exist, covering 15.1 million employees.

ESOPs are most often created to buy shares from the existing owners of a closely held company. Selling a business to an ESOP provides a fair price for the selling owner’s shares, tax benefits for the company (frequently for the seller as well), and a long-term benefit for employees that rewards their contributions to the value of the company. An ESOP is a flexible means of business transition: the ESOP can buy as much or as little of the company as the owners want to sell, and the selling owners can retain whatever role they want in the company while preserving the legacy and values that define it.

An ESOP can also be used solely as an employee benefit plan without selling the company. Some closely held company ESOPs are used this way, as are the approximately 10% of ESOPs that are in publicly traded companies.

Employees in an ESOP do not purchase shares. Instead, the company uses future pretax profits to buy the shares for them, and the ESOP holds the shares in trust on their behalf. Employees are paid cash for the value of their shares in the ESOP after they retire or leave the company. An ESOP gives employees the right to the financial value of their shares and certain limited voting rights; the role of employees in day-to-day governance is up to the company to decide.

This article looks at the mechanics of ESOPs. Our article Using an ESOP for Business Transition focuses on how an ESOP can be used for ownership succession. For a step-by-step guide to assessing whether your company is a good fit for an ESOP, see our ESOP Pre-Feasibility Toolkit.

For a detailed look at how ESOPs work, see our books An Introduction to ESOPs, Understanding ESOPs, S Corporation ESOPs, and Selling to an ESOP and Financing the Deal.

To form an ESOP, the company sets up a special trust designed to hold shares for its employees. The trust is funded by company contributions, which are fully tax-deductible within certain limits. The company contributes new shares of its own stock to the trust, or cash to buy existing shares. Alternatively, the ESOP can borrow money to buy new or existing shares, with the company making cash contributions to the plan to enable it to repay the loan. This leveraged ESOP structure is common in business transitions, as it enables the company to borrow money to buy out the existing owner and then repay the loan with pretax dollars.

Shares within the ESOP trust are allocated to individual employee accounts. Generally, all full-time employees over 21 participate in the plan, with certain exceptions. Allocations are made either on the basis of relative pay or some more equal formula. As employees accumulate seniority with the company, they acquire an increasing right to the shares in their account, a process known as vesting.

When employees leave the company, they receive their stock, which the company must buy back from them at its fair market value unless there is a public market for the shares. Private companies with an ESOP must have an annual outside valuation to determine the price of their shares.

Employees in an ESOP have the right to vote their allocated shares directly on certain major issues such as closing or relocating, but except in publicly traded companies, the company has discretion over whether employees can vote their shares directly in board elections and other decisions. Typically, the ESOP trustee votes the shares, with a duty to act in the interests of the employees as shareholders.

ESOPs are defined contribution retirement plans governed by US retirement plan law. The rules that apply to ESOPs are the same or similar as those that apply to 401(k) and other retirement plans. Congress has been consistently supportive of ESOPs on a bipartisan basis, providing substantial tax benefits as described later in this article.

In return for the ESOP’s tax benefits, companies need to follow rules designed to ensure the benefits of the plan are broadly distributed to employees. There are a few key requirements:

• Eligibility: A high percentage of non-highly compensated employees must be included in the plan; usually, at least all employees who work 1,000 hours in a plan year are included.
• Allocation of benefits: Contributions to the ESOP from the company must be allocated based on relative pay or a more level formula. Pay above a certain amount ($360,000 in 2026) does not count, and any formula other than relative pay needs to be tested to make sure it does not excessively benefit more highly paid people. Examples of alternative allocation formulas include one that caps the pay used in the calculation at a lower level than the current $360,000 limit, or one that gives points for service as well as pay.
• Vesting: Employees must vest at least 20% per year, reaching full vesting within six years, or be 100% cliff-vested (vested all at once) after three years. Companies can choose whether or not to give credit for service before the ESOP.
• Distribution of benefits: ESOP rules are more flexible than 401(k) rules. Benefits must start to be distributed not later than one year after the end of the plan year after an employee retires, dies, or becomes disabled. For any other reason, distribution must start no later than five years after the end of the plan year in which an employee terminates. Distribution can then be in installments for up to five years.
• Diversification: Once an employee has been in the plan for 10 years and is 55 years or older, they must be allowed to diversify up to 25% of the company stock in their account. This rises to a cumulative total of 50% five years later.
• Form of distribution: Companies can distribute the shares or the cash value of the shares. If employees get shares and the company is not publicly traded, the company must offer to buy them back.

For more on the rights guaranteed to employees in an ESOP, see our article on the Rights of ESOP Participants and, for information on distributions, see When Will I Be Paid? The ESOP Participant's Guide to ESOP Distribution Rules.

To determine the value of the company's shares, ESOPs are required to have an annual appraisal of the stock by an independent, outside appraisal firm hired by the plan’s trustee. When ESOPs are used for business transition, the independent appraisal forms the basis for the share price at which the ESOP buys out the selling owners, and the ESOP cannot pay more than this fair market value. The value is based on what a hypothetical financial buyer would pay for the shares. In other words, the ESOP value is what an investor might pay to buy the shares, not what a synergistic buyer (e.g., another company that in some cases might offer a higher price) might pay.

The board appoints a trustee to act as the legal shareholder. The employees are beneficiaries of the trust, not direct shareholders. The trustee votes the shares. In closely held companies, employees must be able to direct the voting of the shares in a small number of situations, such as an asset sale or (in some cases) a merger of the company, but the extent of other direct voting rights is decided by the company. In public companies, employees can direct the voting of their shares in all matters. The role of employees in day-to-day governance is up to the company to decide.

The ESOP trustee’s most important duties are to make sure that the valuation is done properly and that the plan rules and administration are within the law. Trustees almost never get involved in operational issues in the company. Most ESOP companies voluntarily choose to add outside board members, but there is no legal requirement to do so.

The simplest way to finance an ESOP is to contribute cash to the trust. The trust then uses this cash to purchase shares. The size of the contribution is discretionary. The company can also contribute shares directly to the trust. Either way, these contributions are tax-deductible.

More commonly, companies borrow money to purchase a larger block of shares. The company then reloans the money to the ESOP, which uses the funds to purchase the shares. As this internal loan is repaid, the shares are allocated to employee accounts. This internal loan is almost always longer than the loan to the company so that the shares can be allocated more gradually. The loan can come from banks, private capital sources, and/or seller notes. With seller notes, sellers agree to be paid over time with a reasonable rate of interest that reflects the risk of the loan. Some sellers also choose to be repaid partly in warrants, which are the right to purchase shares at the sale price for some years into the future.

ESOPs have substantial tax benefits for both the company and the selling owner(s):

• Company contributions to fund an ESOP are tax-deductible in whatever form they take. A company can contribute cash on a discretionary basis year-to-year and take a tax deduction for it, whether the contribution is used to buy shares from current owners or to build up a cash reserve in the ESOP for future use. Companies can also issue new or treasury shares directly to the ESOP and deduct their value, though this dilutes existing owners. And when an ESOP borrows money to buy shares—the most common structure in business transitions—the company's contributions to repay that loan are fully deductible, meaning the buyout is effectively financed in pretax dollars. A $10 million stock redemption that would normally require roughly $14 million in pretax earnings costs only $10 million through an ESOP.
• Through the “1042 rollover,” sellers to an ESOP can defer taxes on capital gains by reinvesting the proceeds in stock and bonds of US operating companies (“qualified replacement property”). No taxes are paid until the replacement investments are sold. Any investments held until death are stepped up in basis, so no capital gains taxes are paid. The full deferral applies only to sales to an ESOP in a company that is or converts to C status and in which the ESOP owns at least 30% of the stock. A 10% deferral for sales to ESOPs in S corporations will become effective in 2028.
• S corporations (which pass through taxes to their owners and generally fund the payment of those taxes through distributions) do not have income taxes on profits attributable to an ESOP. That means a 30% ESOP-owned S corporation has no taxes on 30% of its profits; a 100% ESOP-owned S corporation has no taxes at all to fund. The ESOP must receive a pro-rata share of any distributions paid to other shareholders, however.
• Dividends are tax-deductible: Reasonable dividends used to repay an ESOP loan, passed through to employees, or reinvested by employees in company stock are tax-deductible.
• Employees are not taxed on contributions to the ESOP when they are made. Instead, they pay taxes on their ESOP accounts upon distribution, in the same way they would on 401(k) or other retirement plans. The employees can roll over their distributions in an IRA or other retirement plan or pay current tax on the distribution, with any gains accumulated over time taxed as capital gains. The income tax portion of the distributions, however, is subject to a 10% penalty if made before normal retirement age.

See our article Understanding ESOP Tax Incentives and Contribution Limits.

There are several factors to consider in deciding whether setting up an ESOP is right for your company. While the tax advantages are substantial, ESOPs do have limits and drawbacks. Companies considering an ESOP should weigh the following:

Are you profitable enough to fund the ESOP and still run your business? Because most ESOPs are buying shares, this means you have to have enough cash available to run the business and make the purchase. Private companies must repurchase shares of departing employees, and this can become a major expense that must be carefully modeled against future cash flows.

Can you cover the costs of setting up an ESOP? The costs of setting up an ESOP for business transition is substantial, about 2% to 4% of the total transaction. This compares to about 4% to 9% when selling to another buyer, but it is a cost the company needs to be able to absorb. Generally, companies with fewer than 20 to 30 employees and $1 million in EBITDA are not good candidates.

Are the rules acceptable? While there is a lot of flexibility in plan design, including being able to provide select employees with other forms of equity outside the ESOP, some owners only want certain employees to be owners. That will not work in an ESOP.

Are you mostly focused on getting the highest price for your company, or is your legacy more important? ESOPs offer a value based on what a willing financial buyer would pay, but some companies can attract a synergistic buyer who will pay more. The ESOP tax benefits may offset this in some, but not all, cases. If price is the sole or main consideration, an ESOP may not always be the best choice. In addition, if you finance all or part of the deal with seller notes, you can get an interest rate somewhat higher than senior debt and/or get part of the proceeds in warrants that allow you to benefit from future appreciation in your company's stock price growth. 

Is there successor management? After the seller leaves, there needs to be a team in place to run the company successfully.

If you cannot finance the sale with outside debt, is a seller note acceptable? Seller notes are often part of ESOP deals, and always part of 100% ESOP transactions. If sellers need the money up front or are unwilling to take the risks of a note, an ESOP may not be the best choice.

Is your corporate form eligible? The law does not allow ESOPs to be used in partnerships and most professional corporations. ESOPs can be used in S corporations, but do not qualify for the rollover treatment discussed above and have lower contribution limits.

See our article on reasons not to do an ESOP for more discussion of this.