How an ESOP Works

An employee stock ownership plan (ESOP) is a retirement plan that invests in employee securities and allocates shares to plan participants. Learn the full mechanics and nuances behind these broad-based benefit and business transition strategies.

Get our easy-to-follow "How ESOPs Work" guide.

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ESOPs are Defined Contribution Plans

Unlike other ERISA-authorized retirement plans, an ESOP acquires a sponsor company's stock on behalf of plan participants. Employee owners do not pay out of pocket for shares. Instead, the sponsor company secures financing and repays those loans on the trust's behalf.

Eligible employees receive ESOP shares proportionally to their annual wages. Stock is usually allocated over multiple years. Sponsor companies repurchase these shares (at fair market value) when a plan participant departs or retires.

Join employee ownership expert Larry Kaplan for a walk-through of the ESOP share acquisition, allocation, and repurchase process.

More Employee Ownership Questions? We Can Help.


When CSG was founded in 2000, we made education a priority. That remains central to everything we do. So, if you have questions about forming an ESOP or operating an employee-owned company, you've come to the right place.

Look below for answers to frequently asked questions.

EMPLOYEE OWNERSHIP BASICS

Are there different types of employee stock ownership plans?

Yes. The two most common types are contributory and leveraged ESOPs. Contributory plan sponsors periodically issue new shares to an employee trust. Cash can also be contributed to a trust so that it may purchase company stock. In a leveraged plan, an employee trust borrows money to purchase an equity stake from a company sponsor.


Are partial sales permitted?

Yes. Also known as minority ESOP transactions, these strategies enable targeted shareholder exits and partial liquidity events. Sponsor companies maintain the freedom to explore various transaction options, while individual shareholders can retain non-ESOP equity. Additional shares can be sold to a company's employee stock ownership trust at a later date.


What laws govern ESOPs?

The Employee Retirement Income Security Act of 1974 (ERISA) codified the modern ESOP, set plan standards, and gave the Department of Labor oversight jurisdiction. Subsequent, bipartisan legislation has both clarified regulations and expanded the set of tax incentives available to ESOP stakeholders.


 
ESOPs AS M&A ALTERNATIVES

How do ESOP sales differ from other transactions?

ESOPs offer privately-held companies continued independence, unique tax advantages, and employee benefits. Post-transaction oversight of an employee-owned business rests with the firm’s board of directors, and selling shareholders often maintain meaningful roles.


Are certain companies better suited for leveraged ESOPs?

Leveraged ESOPs are industry-agnostic, but private companies with taxable income and at least 10 employees are generally better candidates. Common use cases include family business ownership transitions, management buyouts, partner exits, and partial liquidity events for owners who want to stay with their companies.


How do selling shareholders receive cash at close?

Many third-party lenders, including major banks and funds, help finance leveraged ESOPs. These loans are secured by plan sponsors on behalf of their employee trusts. Senior debt, without personal guarantees, is commonly used to provide up-front cash to sellers. Seller notes are also a standard ESOP financing component.


 
TAX ADVANTAGES

What is a 1042 Rollover?

An ESOP-exclusive benefit, this tax-deferral strategy enables selling shareholders to defer and potentially eliminate capital gains burdens on their sale proceeds. To earn the benefit, a seller must reinvest their proceeds in Qualified Replacement Property within 12 months of their ESOP transaction date.


Can employee-owned companies earn tax incentives? 

Yes. When shares are transferred to an employee stock ownership trust, sponsor companies may earn state and federal income tax deductions equal to the fair market value of that stock. In addition, 100% ESOP-owned S corporations can become income tax-free in perpetuity.


Are employee owners entitled to tax benefits?

ESOP participants can roll plan benefits into other tax-deferred retirement accounts, including 401(k)s and IRAs. Rollovers must be completed within 60 days of a plan distribution. Otherwise, distributions and dividends are subject to standard taxes and early withdrawal penalties.


 
MANAGING ESOP-OWNED COMPANIES

What is an ESOP trustee’s role?

A trustee is the employee stock ownership trust’s shareholder of record. They have a fiduciary obligation to all plan participants. During an ESOP formation, a trustee represents and negotiates on employees’ behalf. Post-transaction, they ensure the ESOP’s terms are followed and executed by the plan’s sponsor.


Who runs an ESOP-owned business?

The company’s board of directors oversees management and operations. The ESOP trustee typically does not serve on the board. Instead, the trustee maintains an oversight role and votes the employee-owned shares in the event of a major transaction, such as a sale, merger, acquisition, or recapitalization.


Can a plan be modified or terminated?

Yes. With a trustee’s consent, plan terms can be modified. In addition, ESOP financing can be restructured, and follow-up transactions—including secondary sales, stock repurchases, and plan terminations—are common. Under certain circumstances, a sponsor company’s board of directors can replace a plan’s trustee.