How to Explain ESOP

Employee stock ownership plans (ESOPs) are plans under which company owners sell part or all of their company to the employees. ESOPs are usually set up for tax purposes, and so the owner of the company can monetize some/all of his shares in the company. Most ESOPs are structured as a retirement benefit so that employees receive stock in the company they work for as part of their compensation.

History of ESOPs

Modern ESOPs with the attendant tax benefits came into existence in late 1974 with the passage of the federal Employee Retirement Income Security Act (ERISA). ERISA created the tax benefits for corporations and corporate owners, and opened the door for this new retirement benefit scheme. Within a few years it had become a popular plan, especially for larger companies, and by 2003 over 10 million Americans were participating in ESOPs.

ESOPs Are a Retirement Benefit

ESOPs are structured as a retirement benefit, often very similar to 401k retirement plans. But with ESOPs, all of your retirement dollars are buying stock in your company -- unlike other retirement plan funds, which might be invested in other stocks, mutual funds or bonds.

Benefits to the Company/Company Owner

There are numerous benefits to companies establishing ESOPs. First and foremost are the numerous tax advantages to ESOPs that have become law with the many ERISA amendments over the years, which generally makes the overall costs of funding ESOP retirement plans less to companies than with other types of retirement plans. Also, companies can also use ESOPs as a way to raise capital for expansion or acquisition plans.

Benefits to Employees

ESOPs benefit employees by providing a retirement plan that offers tax-deferred retirement savings. Often when employees become "owners" of a company, morale improves and the overall productivity of the operation increases.

ESOPs Have Risk

It is important to keep in mind that ESOPs have risks just like any other retirement investment. People who invested their 401ks in mutual funds lost a lot of money in the financial crisis of 2008. You are investing your retirement in the future of your company, and if the stock goes down significantly so will the amount of money in your retirement account. The case of Polaroid is a good cautionary example. Polaroid started an ESOP to ward off a takeover in 1989, but the market for Polaroid cameras dropped off and by 2001 the stock was almost worthless, and retirees received just a few cents for each shares they owned.

References

• National Center for Employee Ownership: How an Employee Stock Ownership Plan (ESOP) Works
• National Center for Employee Ownership: The Rights of ESOP Participants
• Cornell University: Employee Stock Ownership Plans (ESOPs): Legislative History
• The Boston Globe: Polaroid Employees Pay Price for Helping to Save Company from Takeover