ESOPS 101

Fundamentally, ESOPs are tax-qualified retirement plans, just like 401(k) plans are. However, while a 401(k) plan’s investments are diversified, an ESOP primarily invests in the stock of the company that sponsors it. So instead of an employee’s account being invested in diversified investments like mutual funds, it’s invested in the stock of the company that the employee works for. However, employees usually do not make contributions to the ESOP – instead, all of the contributions are made by the employer.

An ESOP can own any percentage of the company that sponsors it. Several ESOPs own 100% of the sponsoring company, and that comes with significant tax advantages.

With an ESOP, shares of the company are owned by the ESOP trust – not the employees themselves – but the shares are allocated to accounts of employees. When employees leave the company, they receive distributions based on the value of the vested shares that were allocated to the employees. Therefore, the employee’s payment is bigger if the company is more valuable. And that gives employees the incentive to work harder and smarter, because that will pay off for them after they leave the company.

In this section, we'll discuss why a business owner should consider an ESOP and how ESOPs are formed (along with the cost of doing so). An ESOP can provide significant tax savings to both the selling shareholder and the company, and we discuss those. However, ESOPs aren't without risks, so we'll discuss some of those. Finally, we'll talk about what makes ESOP companies special, which is why they tend to perform better than their competitors.