ESOPs: Making company ownership accessible.

ESOP Basics

The concept of an employee-owned company goes hand in hand with the American Dream. It's a way for workers to unlock a prosperous life and enjoy the freedom that comes with financial stability and earned wealth.

One path for company ownership is through an Employee Stock Ownership Plan (ESOP). An ESOP is a type of employee benefit plan that gives employees an ownership interest in the company they work for.

Let's explore the basic elements of an ESOP and how it's evolved over the years.

What is an ESOP?

An ESOP is a financing tool that facilitates employees obtaining an ownership stake in their company. Today, ESOPs are used by various companies, including small businesses, large corporations, as well as public and private companies.

But ESOPs are a highly complex, narrowly defined type of employee ownership plan. Learn more about the factors and benefits that help shape an ESOP.
ESOPs can take different forms, but in general, they involve a trust that is established to hold company stock on behalf of employees. Employees then become beneficiaries of the trust and, over time, typically receive more stock the longer they’re employed with the company. Since employees receive more shares the longer they stay with the company, ESOPs also tend to have lower employee turnover rates than traditional companies.
Many people are aware of the Employee Retirement Income Security Act of 1974 (ERISA) as it relates to worker protections like COBRA and HIPAA. But ERISA also included language that both defined ESOPs and assigned power to the Department of Labor (DOL) to ensure plans are structured with appropriate participation and administrated with the oversight of a fiduciary.

ERISA also established legal rights for plan participants and beneficiaries, including:
• The right to receive plan information,
• The right to sue for benefits, and
• The right to challenge plan decisions.


This language was designed to ensure that employee benefits are secure and that employees can receive the benefits they have been promised. And 50 years later, the DOL still evaluates and regulates ESOPs based on ERISA.
The core benefit of the ESOP is that it gives workers the opportunity to own a stake in the company they work for. In addition to a worker's wages and a separate 401(k) plan, having ownership in a company can give employees improved financial security and enables them to build wealth through the shared success of the company. Additionally, ESOPs can lead to increased job satisfaction, engagement, and motivation, as employees feel more invested in the success of the company. Importantly, ESOPs grant ownership to employees as a reward for their hard work, at no incremental out-of-pocket cost to the employee, and ESOP grants are not intended to replace any wages or benefits workers would otherwise receive.
According to Gallup, 66% of workers describe themselves as “not engaged” or “actively disengaged.” While this alarming figure is a top concern for many companies, ESOPs generally have more motivated and engaged workers. The shared interest in seeing the company succeed organically improves internal communications and drives employees to seek operational efficiencies that reduce costs and help the company’s overall bottom line. ESOPs also tend to have lower turnover rates and related costs as employees have a vested interest in staying with the company longer to grow their ownership share.

There are also substantial tax benefits for ESOP companies, including exemption from many federal and state taxes. Contributions made by the company to the ESOP trust are also tax-deductible. The idea is that the money saved from tax benefits can be reinvested in the company, allowing these companies to implement organizational improvements that further set up the ESOP for success, which ultimately benefits the workers and the economy.
ESOP Basics Divider
The Timeline

The evolution of the ESOP.

ESOPs were born from a need to sustain the vision our forefathers had for our country – that hard work, perseverance, and a dream can help pave a path of upward mobility for all Americans.

Learn about the history of the ESOPs and the pivotal events that have shaped it along the way.

The birth of ESOPs
(1950s-1960s)

The ESOP was originally conceived in the 1950s by Louis O. Kelso, a lawyer, investment banker, and aspiring economist from San Francisco. Kelso was concerned about the concentration of wealth in the U.S. and the growing “income gap” between common laborers and the wealthy. He argued that employee ownership would lead to not only a more equitable distribution of wealth, but also a more efficient economy. The theory held that employees, as owners, would be motivated to work harder and implement operational improvements that would lead to higher productivity per capita.

ESOPs receive political
support (1970s)

Kelso sought tax legislation as the means to encourage employee ownership in U.S. corporations. He befriended the former Senator Russell Long, and the two testified extensively before Congress during the early 1970s. They argued that the benefits of employee ownership were so great as to justify tax benefits for companies that proactively placed stock in the hands of their workers.

With politicians across the aisle embracing their vision, Kelso and Long had secured broad bipartisan support that would eventually help them succeed in passing new tax legislation encouraging employee ownership.

Congress passes
ERISA (1974)

On January 2, 1974, congress passed the Employee Retirement Income Security Act of 1974 (ERISA), the initial tax law regarding ESOPs. This legislation was expanded and modified several times throughout the decade and into the early 1980s. Collectively, this series of laws relating to ESOPs provided the following tax incentives to increase employee ownership:
In lieu of making ordinary pension contributions, a company could now contribute stock (or cash to buy stock) to a trust set up for the benefit of employees. Over time, as employees provided service to the company, this stock vested and was attributed to specific employees. Just as pension contributions were tax deductible, so would be contributions to these employee trusts. The only difference was, rather than building up future benefits or a cash retirement fund, employees were now building up ownership in their company.
This provision allows commercial lenders to avoid taxes on 50% of the interest income they receive on loans made to employee trusts (or to companies that, in turn, make “mirror loans” to their employee trusts) for the purpose of buying company stock. Because of the tax-advantaged nature of the loan, banks were willing to lend money for such purposes at below-market rates. Though this provision would eventually be removed from ERISA in the 1980s, including a similar provision in future legislation would strongly benefit ESOPs today.
Over time, Congress noted that employee ownership was not increasing among small businesses. One reason for this was that the tax code made it more attractive for a small business owner to sell to a large company than to sell to their employees. If the owner sold to a large company in exchange for stock, capital gains could be deferred until the stock was ultimately sold. However, capital gains were due immediately if the owner sold the business to an employee trust (for cash). Congress and President Reagan changed this with a 1984 Deficit Reduction Act provision. Now, when an owner sells at least 30% of the equity in their company to employees or an employee trust, the owner could reinvest the proceeds on a tax-deferred basis. Generally, the proceeds had to be reinvested in stock or bonds of American companies to receive such treatment.

ESOPs gain momentum
(1980s)

In the early 1980s, ESOPs were mostly used as a tool for companies to raise capital and provide a way for employees to purchase company shares. The first ESOPs were typically set up as trusts, with the company contributing stock to the trust and employees receiving shares based on their salary or length of service.

According to ESOP Association in Washington, the number of ESOPs in the U.S. grew from 1,500 in 1981 to 10,000 in 1990. The notable success of ESOPs, coupled with new tax incentives brought in through tax legislation passed in 1984 and 1986, helped promote the adoption of the ESOP model throughout the 1980s.

However, by the late 1980s, an unexpected application of ESOPs emerged – their use to save failing companies or avoid unwanted corporate takeovers. But this strategy proved to be shortsighted. Failing companies that turned to ESOPs as a solution often found themselves still facing major financial issues, including bankruptcy or the same takeovers they had tried to avoid in the first place. And while this application only accounted for a small fraction of all ESOPs, the negative attention these ESOPs received overshadowed the successes of thriving ESOPs.

Public criticism slows
ESOP growth (1990s-2000s)

Since the early 1990s, the level of ESOP activity has declined dramatically. While certain changes to regulation and taxation were part of this decline, the biggest factor was a dramatic shift in political and public opinion. During this period, ESOPs were plagued by multiple high-profile bankruptcies and scandals. All were heavily covered by financial and mainstream media.

The most prolific case was the Enron scandal in 2001. Top executives at Enron took advantage of its ESOP structure by falsely reporting profits and hiding debt, all while selling their own shares to employees, causing the company's stock to artificially inflate. This plummeted the company's stock value and left employees with little or no value in their retirement plans.

Bad actors like Enron have hindered ESOPs because they have led to a loss of trust in the integrity of the companies that implement them. These scandals also led the IRS and the Department of Labor to implement stricter regulations on ESOPs. These regulations included requirements for independent appraisals of the company's stock and for more detailed reporting on the operations of the ESOP.

Changes to tax laws were another key reason ESOPs growth declined during this period. In the 1980s, there were significant tax incentives for companies to establish ESOPs, including deductions for contributions to the plan and tax-free rollovers of stock to employees. However, these incentives were gradually phased out over the years, making it less attractive for companies to establish ESOPs.

A need to modernize
legislation (Present)

Today, more than 6,500 ESOPs in the U.S. cover 13.9 million participants, of whom 10.2 million are active employees. You may have even visited an ESOP recently – notable retail ESOPs include Publix Super Markets, WinCo Foods, and WaWa, Inc., to name a few.

ESOPs have created wealth, economic security, and consumer purchasing power for the millions of employees fortunate enough to work for employee-owned companies. But ESOPs only make up a small fraction of all companies, which makes this an unlikely option for most workers.

ESOP growth remains stagnant because current legislation complicates the implementation process, deterring most companies from considering this path. Much like companies and employees have evolved over the past 50 years, the legislation the DOL relies on to regulate also needs to evolve.

As people become increasingly aware of the widening wealth gap in the U.S. – the same issue that compelled Louis Kelso to create the concept of the ESOP in the first place – efforts like this must be put in place to avoid the ‘American dream’ becoming folklore for future generations.
BiPartisan Support

ESOPs unite both sides of the aisle.

ESOP-related legislation has a track record of receiving bipartisan support over the years. The original legislation that’s included in ERISA (1974) passed by near unanimous consent. Since then, many subsequent changes to the ESOP provisions in ERISA – which were part of larger tax bills – have passed with ease. In some cases, the slimmer margins of passage had more to do with the larger bill than with the ESOP provisions.

Votes in favor of amendments that included ESOP provisions.
Explore legislation that passed with support from both sides of the aisle.
1974: Employee Retirement Income Security Act (ERISA) (establishes ESOPs in law)

1975: Tax Reduction Act (created a tax credit for ESOPs)

1978: The Revenue Act of 1978 (added new formalities to ESOPs through creation of IRC § 409A)

1984: Tax Reform Act of 1984 (created new and substantial tax incentives for employers maintaining ESOPs for employees)

1986: Tax Reform Act of 1986 (emphasized the retirement objective of ESOPs by imposing a 10% penalty tax on withdrawals made prior to age 59.5)

1989: The Omnibus Budget Reconciliation Act of 1989 (repealed or limited multiple ESOP tax incentives)

1996: The Small Business Job Protection Act (SBJPA) of 1996 (widened the availability of ESOPs by allowing S corporation shareholders to participate)

1997: Taxpayer Relief Act of 1997 (repealed application of the unrelated business income tax for an employee stock ownership plan that is an S corporation shareholder)

2001: Economic Growth and Tax Relief Reconciliation of 2001 Act (initiated a 50% excise tax on prohibited allocations by S corporation ESOPs)

2002: Job Creation and Worker Assistance Act of 2002 (increased the contribution limits of man qualified retirement plans, including ESOPs)