Employee Stock Ownership Plan (ESOP)

An employee stock ownership plan is a qualified retirement plan whose assets are meant to be the employer's own stock. The tax code defines it at IRC 4975(e)(7) as a defined contribution plan "which is a stock bonus plan which is qualified, or a stock bonus and a money purchase plan both of which are qualified under section 401(a), and which are designed to invest primarily in qualifying employer securities." The IRS describes it in the same terms, as an IRC section 401(a) qualified defined contribution plan that must be designed to invest primarily in qualifying employer securities, and notes that the IRS and the Department of Labor share jurisdiction over some of its features.

Three plans with similar names get confused, and the differences are not subtle. In an ESOP the employer contributes stock, or cash used to buy stock, into a retirement trust; the employee contributes nothing and buys nothing. In an employee stock purchase plan the employee buys shares through payroll deductions, usually at a discount. An employee stock option plan gives the employee the right to buy shares at a set price later. The SEC's own investor education flags the second confusion explicitly, warning that an ESOP "should not be confused with employee stock option plans."

The statutory heart of an ESOP is an exemption from the duty to diversify. ERISA requires a fiduciary to discharge duties prudently and "by diversifying the investments of the plan so as to minimize the risk of large losses, unless under the circumstances it is clearly prudent not to do so." Then 29 U.S.C. 1104(a)(2) carves a hole in it: for an eligible individual account plan, the diversification requirement, and the prudence requirement to the extent it requires diversification, "is not violated by acquisition or holding of qualifying employer real property or qualifying employer securities." Every other feature of the plan follows from that sentence. The law permits a retirement account to be concentrated in a single company's stock, and only in this setting.

Because the concentration is permitted, the counterweights are statutory rather than discretionary. IRC 401(a)(28)(B) requires the plan to let a "qualified participant," defined as an employee who has completed at least 10 years of participation and has attained age 55, elect within 90 days after the close of each plan year in a six-plan-year election window to direct the investment of at least 25% of the account, measured net of any amount covered by an earlier election. In the last year of that window the fraction is at least 50%. The plan satisfies the requirement either by distributing the elected portion or by offering at least three investment options and moving the money accordingly. This provision does not apply to a plan holding publicly traded employer securities, which is governed instead by IRC 401(a)(35): there, amounts attributable to employee contributions and elective deferrals can be divested immediately, employer contributions after three years of service, and the plan must offer at least three diversified alternatives with materially different risk and return characteristics.

Valuation and the put option are what make a private-company ESOP work at all. Shares in a company that is not publicly traded have no market price and no buyer. IRC 401(a)(28)(C) requires that all valuations of employer securities that are not readily tradable on an established securities market be performed by an independent appraiser. And IRC 409(h) gives a participant entitled to a distribution the right to demand that benefits be distributed in employer securities and, where those securities are not readily tradable, "a right to require that the employer repurchase employer securities under a fair valuation formula." That repurchase right, generally called the put option, is the mechanism that turns shares nobody can sell into money. It has exceptions: a plan maintained by an S corporation, or by an employer whose charter or bylaws restrict ownership of substantially all its stock to employees or to the plan trust, may provide for cash distribution instead, with resale rights attached where securities are distributed.

Getting money out has its own timetable. IRC 409(o) requires the plan to provide that, if the participant elects it, distribution of the account will begin no later than one year after the close of the plan year in which the participant separates from service by reason of normal retirement age under the plan, disability or death, or the fifth plan year after the plan year of any other separation, and that it be paid in substantially equal periodic payments over no more than five years unless the participant elects otherwise. Larger balances get a longer maximum period on thresholds the statute adjusts for cost of living. Shares held in an ESOP that carry appreciation over the plan's cost can also raise the net unrealized appreciation rules on a lump-sum distribution, which is a separate decision covered there.

The household consequence is the one worth acting on. A concentrated retirement account at an employer sits alongside a salary from the same employer, and often alongside health coverage and a purchase plan too, so a single company's fortunes drive several parts of one household's finances at once. That structure and what to do about it belong to concentration risk.

The employer establishes the trust and contributes stock, or cash the trust uses to buy stock, and the contributions are allocated to participant accounts, usually in proportion to pay, subject to a vesting schedule. Shares are valued annually, by an independent appraiser where there is no public market. Participants receive account statements showing shares and value but cannot generally sell them. On separation, retirement, disability or death the account is distributed on the schedule in IRC 409(o), in cash or in shares, with the repurchase right applying where the shares are not readily tradable.

A hypothetical example of the diversification election. Rosa is 57 and has 12 years of participation, so she is a qualified participant under IRC 401(a)(28)(B). Her ESOP account is worth $180,000, all of it in company stock, and the plan holds no publicly traded securities.

In the first year of her election window she may direct the investment of at least 25% of the account, which is $45,000, into other options the plan offers or take that portion as a distribution. Suppose she elects the full $45,000. In a later year of the same window the 25% is measured against the account and reduced by what an earlier election already covered, so the election adds to the diversified portion rather than restarting it. In the final year of the window the minimum fraction rises to 50%, which on a $180,000 account is $90,000.

Two features of that arithmetic are worth noticing. The election is a floor the plan must offer, not a ceiling on what a plan may allow. And even fully used, it leaves half the account in one company's stock, which is the intended design rather than a gap in it.

Pros

• The employer funds it. Participants build a retirement balance without contributing their own pay.
• It is a qualified plan, so contributions and growth are not taxed as they accumulate and balances can generally be rolled over on distribution.
• Where there is no public market, the repurchase right under IRC 409(h) converts otherwise unsellable shares into money on distribution.
• Annual valuations of non-traded shares must be made by an independent appraiser.
• For a private company it can keep ownership with the people doing the work rather than with an outside buyer.

Cons

• The account is concentrated in one company by design, and the statute expressly excuses that from the usual duty to diversify.
• The concentration compounds a household's existing exposure, because the same employer usually provides the salary and often the health coverage.
• Participants generally cannot sell shares at will; access runs through the plan's distribution rules rather than through a market.
• Shares in a company with no public market are valued by appraisal rather than priced by buyers and sellers.
• The diversification election is limited, arrives only at age 55 with ten years of participation, and does not reach the whole account.