ESOP (Employee Stock Ownership Plan) tax policy

Policy Guide

An Employee Stock Ownership Plan (ESOP) is a type of employee benefit plan in which employees receive an ownership stake in the company where they work through the receipt of stock. Unlike stock options, with a few exceptions (such as if a union opts not to participate), ESOPs by law must provide shares to all full-time company employees. Academic research over the past three decades has demonstrated that ESOPs, provided they are accompanied with meaningful worker participation in the running of the business, benefit both the employee and the company, creating an employee more vested in the success of the company (resulting in higher productivity per worker) and generating stronger connections to the local community, because ownership of the company is distributed broadly among the local population that works in the company.

ESOPs are a powerful wealth-building tool. As of the end of 2006, 13.7 million Americans were part of the 11,400 firms owned in whole or part by the employees through an ESOP, with a total value of nearly $925 billion or roughly $67,500 per worker-owner. Historically, ESOPs have been most frequently formed to buy out a retiring owner of a family-owned business, which can allow for continuity of the business, helping to preserve local jobs and empowering employees.

Typically, in order to establish an ESOP, a company forms a trust and makes annual contributions to that trust for each participating employee. The allocation formulas and vesting requirements vary company to company, but all workers must be fully vested after seven years. After age 55, an employee may diversify portions of his or her ESOP account. Most companies with ESOPs also include a separate 401(k) plan. A study conducted in the state of Washington, for instance, found that the average 401(k) value was greater for employees in ESOP companies than in non-ESOP companies, meaning that the combined pension value (ESOP and 401(k)) was significantly greater.

Congress has provided many tax incentives for ESOPs. Most estimates suggest that federal tax benefits for ESOPs are worth about $2 billion a year. Particularly important has been the ability of owners that sell 30 percent or more of their company to the employees to defer ("roll over") the capital gains from the sale. Additionally, companies are able to borrow to fund the ESOP plan, which can provide a company with additional tax benefits. The first tax benefit an ESOP receives is the ability for a company to deduct the contributions that it makes to the ESOP plan; and, if the ESOP is leveraged, the company may deduct both principal and interest payments on the borrowed money.

In 1996 and 1997, Congress amended the tax code to also enable ESOPs to own an S corporation. Under federal law, S corporations are exempt from federal corporate income tax; most states follow this provision in their own tax laws. Thus, an ESOP that owns 100 percent of an S corporation may pay no corporate income tax at all. However, according to Steven F. Freeman and Michael Knoll of the University of Pennsylvania, the higher productivity and sales generated by S corporation ESOPs compared to non-ESOP counterparts result in a net gain in revenue to the Federal Treasury of $8 billion a year.

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