What Is an ESOP? How Employee Stock Ownership Plans Work
Employee stock ownership plans give workers company shares inside a retirement account. Vesting, payout dates and the right to sell shares back follow federal rules.
An employee stock ownership plan (ESOP) is a tax-qualified retirement plan that invests mainly in the stock of the company employees work for. The company or a sale to the plan funds the shares, so employees do not buy them; shares are allocated to individual accounts, vest over time and are paid out after you leave. Your summary plan description sets the exact vesting schedule and payment timing.
The IRS describes an ESOP as a qualified defined contribution plan that is a stock bonus plan, or a stock bonus and money purchase plan, designed to invest primarily in employer securities. The IRS and the Department of Labor share oversight, and the IRS keeps an ESOP page with the main rules.
How does a company become employee-owned through an ESOP?
Most often, an owner sells some or all of their shares to an ESOP trust. In a leveraged ESOP, the trust borrows to pay the seller, and the company then makes yearly tax-deductible contributions that the trust uses to repay the loan. As the loan is paid down, shares are released from a suspense account and allocated to employees.
The sale can happen in stages. Bob’s Red Mill, the Oregon whole-grain food maker, says founder Bob Moore set up its ESOP on his 81st birthday in 2010, and the company reports that it became 100% employee owned on April 30, 2020.
A trustee holds the shares and votes them. In a private company, an independent appraiser values the stock at least once a year, and that value sets what accounts are worth and what the plan pays when it buys shares back.
How are shares allocated and when do they vest?
Shares are usually allocated each year in proportion to pay, under a formula in the plan, with limits for very high earners. You do not pay for them out of your wages.
Vesting decides how much of your account you keep if you leave. Federal law sets the slowest schedules a plan may use for employer contributions, as the IRS vesting page explains:
| Years of service | 3-year cliff | 6-year graded |
|---|---|---|
| 1 | 0% | 0% |
| 2 | 0% | 20% |
| 3 | 100% | 40% |
| 4 | 100% | 60% |
| 5 | 100% | 80% |
| 6 | 100% | 100% |
A plan can vest faster than this. Unvested shares you forfeit when you leave are reallocated to the remaining participants.
When do I get paid after I leave?
Later than many people expect. Under Internal Revenue Code section 409(o), a plan must begin distributions no later than one year after the end of the plan year in which you retire, become disabled or die. If you leave for another reason, such as a layoff or a new job, the plan may wait until the year after the fifth plan year following your departure.
Once payments start, the plan can pay in substantially equal installments, at least yearly, over up to five years. Very large balances can be spread over a longer period. Some plans pay sooner; the summary plan description says which rules your plan uses.
At 55, with at least 10 years in the plan, you can also direct the investment of part of your account while still employed. This diversification right lets you move at least 25% of the account out of company stock in each year of a six-year window, and 50% in the final year.
What is the ESOP put option?
If the company’s stock is not publicly traded, it must give you the right to sell distributed shares back to the company at fair market value. Under section 409(h), that put option lasts at least 60 days after the shares are distributed, and if you do not use it, for another 60 days in the following plan year.
If the plan pays out your whole account in one year, the company can pay for the shares in installments over up to five years, with adequate security and reasonable interest. For installment distributions, payment for the shares is due within 30 days after you exercise the put. Many private-company plans simply pay cash, which has the same effect.
How is an ESOP different from an ESPP or stock options?
Each one gives employees a stake in the company, but the money, taxes and timing differ.
| Feature | ESOP | ESPP | Stock options |
|---|---|---|---|
| Who pays for the shares | The company or the plan’s loan | You, through payroll deductions, often at a discount | You, at the exercise price |
| Where shares are held | Retirement trust account | Your brokerage account | Your brokerage account after exercise |
| When value reaches you | After you leave or retire | When you sell | When you exercise and sell |
| Taxed when | On distribution, unless rolled over | On sale, under ESPP rules | At exercise (NSOs) or sale (ISOs) |
| Private company liquidity | Put option to the company | Rare; mostly public companies | Limited until a sale or IPO |
For the other two, see our guides to ESPPs in an acquisition and stock options in an acquisition.
What happens to an ESOP if the company is sold?
The trustee decides how to respond to an offer, and in a private company participants generally get to direct the vote on major corporate events such as a merger or a sale of substantially all assets. If the buyer pays cash, the shares in your account become cash, and the plan is often terminated, with accounts paid out or rolled into another plan. For how other retirement accounts are treated, see what happens to your 401(k) when your employer is acquired.
Bottom line
Ask for three documents: the summary plan description, your latest account statement showing vested shares and the appraised share price, and the plan’s distribution policy. Together they show how much you own today and when you can expect cash after leaving. Questions about rolling a payout into an IRA, or the 10% additional tax on payments before 59 1/2, are for the plan administrator or a tax professional.
FAQ
Do I have to buy shares in an ESOP?
No. Shares are contributed or released to your account by the plan; you do not pay for them from your salary. An ESPP is the program where employees buy shares.
Can an ESOP lose value?
Yes. Your account rises and falls with the company’s stock value, and if the company fails, the shares can become worthless. That concentration is why the diversification right at 55 exists.
Can I roll my ESOP payout into an IRA?
Generally yes. Distributions from an ESOP are eligible rollover distributions in most cases, and a direct rollover avoids immediate tax.
Why is my payout years after I leave?
Federal rules let the plan delay payments for people who leave before retirement, then pay in installments. The delay helps a private company spread the cost of buying back shares.
