How an ESOP works
How employees become owners without spending their own money.
An employee stock ownership plan, or ESOP, is the tool Louis Kelso invented in 1956. Today it is the most common form of employee ownership in the United States. Step through how one works below, or switch to see how it can finance growth.
Set up a trust
The company creates an ESOP trust, a separate legal entity that will own shares on behalf of its employees. An independent trustee looks out for the employees’ interests.
Read all the steps as text
- Set up a trust. The company creates an ESOP trust, a separate legal entity that will own shares on behalf of its employees. An independent trustee looks out for the employees’ interests.
- Borrow the money. A lender provides the money, usually to the company, which relends it to the trust. Sometimes the selling owner is paid over time instead. Employees put in none of their own money.
- Buy the owner’s shares. The trust uses the loan to buy shares from the retiring owner. An independent appraiser sets the price, and the trust can’t pay more than fair market value.
- Hold the shares until they’re paid for. The shares wait in a suspense account inside the trust. They belong to the plan, but they haven’t been paid for yet, so they aren’t in anyone’s account.
- Repay the loan from the company’s earnings. Each year the company contributes cash to the trust, and the trust uses it to repay the loan. Those contributions are tax-deductible, so the loan is repaid with pretax dollars.
- Release shares to employees. As the loan is paid down, shares move from the suspense account into individual employee accounts, most often in proportion to pay. What the company earns pays for them, not the employees.
- Cash out when they leave. Employees earn full rights to their shares over time, within six years at most. When they retire or leave, the company buys back their shares at the current appraised value, and they receive the cash.
What it means for employees
No money out of pocket
In a typical ESOP, employees don’t buy their shares. The company’s contributions pay for them.
An account that grows
Shares are added over time, and their value rises or falls with the company’s. An independent appraiser values them every year.
Vesting
Employees earn full rights to their shares over time, within six years at most.
Cash when they leave
After retirement, payouts must begin within about a year. For other departures they can start later, and they can be paid in installments over as many as five years.
A voice on the biggest decisions
In most private ESOPs a trustee votes the shares, but employees vote directly on major questions such as selling the company.
Draft for John’s review
What it means for business owners
A buyer who keeps the company local
An ESOP lets an owner sell all or part of the company at fair market value, at once or over time, while its name, people and community ties stay in place.
Tax deferral on the sale
If the company is a C corporation and the ESOP owns at least 30% after the sale, the seller can defer capital gains tax by reinvesting in stocks and bonds of U.S. operating companies. This is known as a Section 1042 rollover. A partial version for S corporations begins in 2028.
Tax advantages for the company
Contributions used to repay the ESOP loan are tax-deductible. In an S corporation, profits attributable to the ESOP’s shares are generally not subject to federal income tax, so a company wholly owned by its ESOP pays none.
Obligations to plan for
An independent trustee, an annual appraisal and the duty to buy back shares from departing employees all need planning and funding.
Get expert help
An ESOP is a regulated retirement plan. Owners considering one should work with an experienced ESOP attorney, appraiser and financial advisor.
Ownership in the real world
Companies you know, owned by the people who work there
Thousands of American companies have an ESOP today. Here are a few of the best known, and one that went wrong.
Supermarkets · Since 1930
Publix
The largest ESOP in the country, with about 260,000 employees. Founder George Jenkins believed people who own a stake in a business take better care of it. Today Publix is owned by its employees and the Jenkins family.
Supermarkets · Idaho
WinCo Foods
Employee-owned for more than 30 years. The company says it adds stock worth 20% of each eligible employee’s pay to their ESOP account every year.
Flour and baking · Since 1790
King Arthur Baking
America’s oldest flour company began moving to employee ownership in 1996 and has been 100% employee-owned through its ESOP since 2004.
Whole grains · Oregon
Bob’s Red Mill
Founder Bob Moore turned down offers from big food companies and started an ESOP in 2010, at age 81. He called it “just the right thing to do.” The company became 100% employee-owned in 2020.
A cautionary tale · United Airlines, 1994
Ownership paid for with pay cuts
United’s employees gave up wages and benefits in exchange for 55% of the airline’s stock. Unions and management stayed at odds, and when United filed for bankruptcy in 2002 the employees’ shares lost almost all their value. The lesson Kelso would draw: these workers paid for their stake out of their own pay instead of letting the capital pay for itself, and they had too much of their future riding on one company.
Myths and facts
What people get wrong about ESOPs
Some of the most common misunderstandings, and what is actually true.
Myth
Employees have to buy in or take a pay cut.
Fact
In a well-designed ESOP, employees put in nothing. The company borrows or contributes, and its earnings pay for the shares. When workers have traded pay for stock, as at United Airlines in 1994, it has usually ended badly.
Myth
Employee-owned means the workers run the company.
Fact
That describes a co-op. In most private ESOPs a trustee votes the shares, and employees vote directly only on the biggest decisions, such as selling the company. Day-to-day management stays with managers.
Myth
ESOPs are a last resort for struggling companies.
Fact
Most ESOP companies are healthy businesses. The most common reason to start one is succession: an owner ready to retire who wants to sell to the people who helped build the company.
Myth
ESOPs are a tax loophole.
Fact
Their tax treatment is deliberate federal policy, written into law in 1974 and expanded with support from both parties since. Kelso saw it as giving working people the same access to credit that wealthy investors already had.
Myth
An ESOP is just another retirement plan.
Fact
Legally it is one, which is why employees usually receive the value of their shares when they leave or retire. But Kelso designed it for something bigger: a way for people without savings to buy capital and earn from it.
Common questions
ESOPs, options, co-ops and more, in plain English
The questions people ask most when they first hear about employee ownership.
All four give employees some stake in their company, but they work very differently.
Stock options give you the right to buy shares later at a set price. You pay to use them, and if the stock never rises above that price they are worth nothing. RSUs are shares granted to you that vest over time. They cost you nothing, but they are usually given only to some employees. An ESPP lets you buy company stock at a discount, often up to 15%, out of your own paycheck.
An ESOP is different in the way Kelso cared about most. It covers nearly all employees, and the shares are paid for out of the company’s earnings rather than out of workers’ wages or savings. The capital pays for itself.
In a cooperative, members own the business together and each gets one vote, whatever they put in. Co-ops give workers real control, but they can be hard to finance and grow. An ESOP works inside an ordinary corporation, so companies of almost any size can use one, and employees’ stake grows as the loan is repaid. Both broaden ownership. They just do it differently.
No. The company contributes shares, or the cash to buy them, to a trust that holds them for employees. Workers do not use their own savings or wages. Shares usually vest over several years, so employees build up ownership the longer they stay.
You keep your vested shares and receive their value. In a private company, the company must buy them back from you at a fair market value set by an independent appraiser, and the payout is often made in installments over several years. You can usually roll it into an IRA to keep its tax advantages.
It can be. If the company struggles, your job and your ownership are affected at the same time. That is why an ESOP is meant to sit alongside other savings rather than replace them, and why the law lets longer-serving employees nearing retirement move part of their account into other investments. Many ESOP companies also offer a separate retirement plan. Kelso saw broad ownership of many kinds of capital, not just your employer’s, as the long-term goal.
No. Some of the best known, like Publix and W.L. Gore, are very large, but most ESOP companies are small and mid-sized private businesses. For an owner who is ready to retire, selling to an ESOP is a way to pass the business to the people who helped build it and keep it independent.
No. The ESOP was the first of eight financing plans Kelso designed, and it is by far the most widely used. Others would let customers own a share of the utilities they depend on, residents own the infrastructure in their community, or citizens own a stake in new public enterprises. The idea is the same each time: let people without savings buy productive capital on credit and pay for it out of what it earns.
His ideas did not fit either political camp. Some on the left saw him as too devoted to capitalism, and some on the right thought broadening ownership sounded too radical. The work was also technical, and corporate finance rarely makes headlines. Yet the ESOP he invented in 1956 is now written into federal law, and it is how millions of Americans own a piece of where they work.
Sources
This page explains how ESOPs generally work. It is not legal, tax or investment advice.
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