Employee Stock Ownership Plan (ESOP) Basics

ESOPs Are Employee Benefit Plans Funded by the Company

An ESOP is a "defined contribution" employee benefit plan, just as a 401(k) is. Unlike a 401(k), an ESOP is designed to mainly hold company stock; it can hold any percentage of the company and often owns 100%. Employees do not hold stock directly; rather, the ESOP acquires the stock and holds it, along with any other assets such as cash, in accounts under a trust for employees. Employees are the "beneficial owners" of their account assets. As a rule, contributions to the ESOP come solely from the company, not employees, and can take the form of stock, cash to buy stock from existing owners, or both. Employees vest in their accounts over time and receive distributions from the plan after terminating employment (and in some instances earlier than that).

How ESOPs Work

The following diagram adapted from our educational video What Is an ESOP? shows how an ESOP works in one typical case: a privately held C corporation. The company creates the ESOP and its trust, the company funds the trust, the trust then buys stock from the owner(s) and puts it in accounts for employees, and employees later receive the value of their accounts (usually after leaving the company). The rest of this article describes this in more detail.

ESOPs Are the Main Form of Employee Ownership in the US

More than 6,400 US companies have ESOPs, as of 2026 there are more than 15 million ESOP participants, counting former employees who have yet to receive all of their distributions from the plan. This is more than any other form of employee ownership in the US. More than 90% of ESOPs are in private companies. See A Statistical Snapshot of ESOPs.

ESOPs Must Be Broad-Based and Cannot Be Used as Individual Awards

ESOPs are governed by the Internal Revenue Code and the Employee Retirement Income Security Act (ERISA), and under those rules, they must be broad-based; usually, all full-time employees over age 21 participate. They cannot be used to selectively award individual employees, unlike equity compensation grants such as stock options.

ESOPs Offer Significant Tax Incentives for Companies

As an employee benefit plan whose purpose is to acquire company stock and hold it for employees, an ESOP already offers private companies a way to buy out a departing owner while rewarding employees with an ownership stake, but the ESOP tax incentives provide another major advantage:

• Within limits, the company can deduct contributions it makes to the ESOP, including to both repay principal and pay interest on ESOP loans. Whereas the company's ESOP contributions used to buy shares from owners are fully tax-deductible, redemptions of stock like this are not deductible in any other purchase of company stock.
• In C corporations, the company can deduct dividends paid on ESOP-held stock.
• In private C corporations, selling owners can indefinitely defer taxation on their gains by reinvesting in securities of other companies if the ESOP owns 30% or more of the company at the time of sale.
• In S corporations (where taxes are passed through to the owners and usually funded by distributions from the company), the ESOP is not subject to tax on its ownership, so if an ESOP owns all the stock (a common situation), there are no tax bills for the company to fund. See S Corporation ESOPs.

ESOPs Are Used for Buying Out Company Owners and Many Other Purposes

The most common use of ESOPs is to buy out the owner(s) of a private company. They can also serve many other functions, often concurrently, such as:

• To align employee/company interests, helping create an ownership culture
• To acquire capital (the company borrows through the ESOP and repays the loan with pretax dollars)
• To divest a subsidiary, division, or product line through an ESOP buyout
• To use an ESOP to acquire another company or part of one
• To create a tax-efficient corporate structure through an S corporation ESOP
• To repurchase public company shares from the market using pretax dollars
• To restructure existing benefit plans by replacing them with an ESOP, or simply adding one (including combining an ESOP and a 401(k) in a "KSOP")
• To bolster the market for thinly traded shares, e.g., in community banks

The ESOP Cannot Pay More Than Fair Market Value for Stock and Must Cash Out Participants at Fair Market Value

The vast majority of ESOPs are in private companies, where there is no public market to set a stock price, so the law protects participants by requiring the ESOP to pay no more than fair market value (FMV), as set by an independent appraiser, when buying shares from the owners, and to use FMV when cashing out participants. ESOP-held stock in private companies must be valued yearly by an appraiser, so even absent any transactions, values in participant account statements will be current.

Allocating Shares to Accounts, Vesting, and Diversification

ESOPs cannot discriminate in favor of highly compensated employees. Allocations to employee accounts must be based on relative pay (in which case pay above a certain amount is disregarded, making allocations more equal) or another nondiscriminatory formula. Vesting (acquiring a nonforfeitable right to one's account assets) must be complete after no longer than six years. After reaching age 55 and being in the plan for at least 10 years, participants have the right to partially diversify out of company stock (this may take the form of alternative investments or just giving stock or cash to employees).

Plan Governance and Participant Rights

The ESOP and its trust are run by a trustee appointed by the board. The trustee, the legal owner of the ESOP's assets, is legally bound to act prudently, with the highest standard of care, in the exclusive interests of plan participants. At a minimum, participants have the right to direct the trustee's voting of company stock on certain major issues such as a corporate merger (in public companies, they can vote on all matters). Participants must be given a summary of the plan's provisions, annual benefit and vesting statements, and notifications of benefit eligibility. They have the right to access plan documents but do not have the right to see the ESOP valuation report or purely corporate information such as executive salaries, company financial information, and shareholder names.

Employees Are Paid the Value of Their Vested Accounts After Leaving

After leaving the company, employees receive (to the extent they are vested) either the stock in their accounts or the value of the stock. (S corporations have limits on how many shareholders they have, so they are allowed to distribute only cash, not the shares themselves.) If the company is privately held, it must offer to buy any stock distributed back from the departing employees at its appraised fair market value. There are a few situations where ESOP participants may receive distributions while still employed, such as if they diversify out of company stock or they receive dividends paid on their shares. Employees are taxed only when they receive distributions, and even then can roll them over to an IRA or a retirement plan to postpone taxes.