Know the Law: How Does an Employee Stock Ownership Plan Work?

John Bentas
Counsel, Corporate Department
Published: Union Leader
July 6, 2015

Q:   I own a business that I am proud to say is successful due in very large part to my fantastic team.  I am wondering if an employee stock ownership plan would both reward my team and keep long-term employees involved after I retire.  How does it work?  

A:  An Employee Stock Ownership Plan (ESOP) can be a valuable mechanism to reward employees, provide liquidity for shareholders and promote productivity and employee loyalty in a company. Notably, an ESOP can do all of these things in a tax efficient manner.

An ESOP is a retirement plan that invests primarily in the shares of your company.  The ESOP operates through a written plan and is administered through a trust.  The formation and administration of an ESOP can be complicated, but with proper guidance from professionals, the uses and benefits can far outweigh these complexities.

An ESOP can create a market for the shares of your company where one might not already exist.  There is some latitude on how an ESOP transaction can be structured.  In particular, the transaction can be structured to provide a gradual transition of the business from current owners to the ESOP.  In many traditional  transactions, third parties have little interest in acquiring a minority position in a company.  As a result, an ESOP can be excellent tool for succession planning both for liquidity and transition reasons.

An ESOP can also encourage a culture within a company of participation and ownership.  An ESOP can reward employees with company ownership.  Employees see the benefits of their work through increases in the value of their ESOP accounts as the value of the company shares increase.  Owning stock through an ESOP allows employees to share in the growth of their company.

Lastly, an ESOP can have significant tax benefits to the company, selling shareholders and employee-participants.  An ESOP can use tax-deductible corporate earnings to buy shares from owners.  Employee-participants may defer recognition on any gain on the value of their allocated stock until a future date.  Most importantly though, an employee does not pay anything out of his or her pocket to get this benefit.  It is a win-win for the employee.

An ESOP should be a consideration for any closely held company considering (1) succession planning, (2) transition of its management and control to executive-level employees, (3) ways to reward employees at all levels for their contributions to the company, or (4) measures for increasing productivity and loyalty of its entire workforce.