Employee stock ownership: Difference between revisions

An employee stock ownership plan (ESOP) is a defined contribution plan that provides a company's workers with an ownership interest in the company. In an ESOP, companies provide their employees with stock ownership, typically at no cost to the employees. Shares are given to employees and are held in the ESOP trust until the employee retires or leaves the company, or earlier diversification opportunities arise.

There are annual limits on the amount of deductible contributions an employer can make to an ESOP. ESOPs are governed by federal pension laws, called the Employee Retirement Income Security Act, or “ERISA”. ERISA sets forth clear requirements to ensure that there can be no ‘preferred’ classes of participants in an ESOP; all employees must be treated proportionally the same. Internal Revenue Code section 404(a)(3) provides for an annual limit on the amount of deductible contributions an employer can make to a tax-qualified stock bonus or profit-sharing plan of 25 percent of the compensation otherwise paid or accrued during the year to the employees who benefit under the plan.

The National Center for Employee Ownership estimates that there are approximately 11,300 employee stock ownership plans for over 13 million employees in the United States.^[1] Notable U.S. employee-owned corporations include the 150,000 employee supermarket chain Publix Supermarkets, McCarthy Building Company and photography studio company Lifetouch. Today, most private U.S. companies that are operating as ESOPs are structured as S corporation ESOPs (S ESOPs).

In the mid-19th century, as the United States transitioned to an industrial economy, national corporations like Proctor & Gamble, Railway Express, Sears & Roebuck and others recognized that someone could work for the companies for 20 plus years, reach an old age, and then have no income after they could no longer work. The leaders of those 19th century companies decided to set aside stock in the company that would be given to the employee when she or he retired.

In the early 20th century, when the U.S. sanctioned an income tax on all citizens, one of the biggest debates was about how to treat stock set aside for an employee by her employer under the new U.S. income tax laws.

ESOPs were developed as a way to encourage capital expansion and economic equality. Many of the early proponents of ESOPs believed that capitalism’s viability depended upon continued growth, and that there was no better way for economies to grow than by distributing the benefits of that growth to the workforce.^[2]

In 1956, Louis Kelso, invented the first ESOP, which allowed the employees of Peninsula Newspapers to buy out the company founders.^[3] Chairman of the Senate Finance Committee, Senator Russell Long, a Democrat from Louisiana, helped develop tax policy for ESOPs within the Employee Retirement Income Security Act of 1974 (ERISA), calling it one of his most important accomplishments in his career.^[4] ESOPs also attracted interest of Republican leaders including Barry Goldwater, Richard Nixon, and Gerald Ford, and ESOPs won praise from Ronald Reagan.^[5]

In 2001, the United States Congress enacted Internal Revenue Code section 409(p), which effectively requires that S ESOP benefits be shared equitably by investors and workers. This ensures that the ESOP includes everyone from the receptionist to the CFO. ^[6]

To establish an ESOP in the U.S., a firm sets up a trust and makes tax-deductible contributions to it. All full-time employees with a year or more of service are normally included. The ESOP can be funded through tax-deductible corporate contributions to the ESOP.

Discretionary annual cash contributions are deductible for up to 55 percent of the pay of plan participants and are used to buy shares from selling owners. Alternatively, the ESOP can borrow money to buy shares, with the company making tax-deductible contributions to the plan to enable it to repay the loan. Contributions to repay principal are deductible for up to 25 percent of the payroll of plan participants; interest is always deductible. Dividends can be paid to the ESOP to increase this amount over 25 percent. Sellers to an ESOP in a closely held company can defer taxation on the proceeds by reinvesting in other securities. In S corporations, to the extent the ESOP owns shares, that percentage of the company's profits are not taxed: 100 percent ESOPs pay no federal income tax, but the profit distribution to the participants is taxed, just as in any S corporation. Employees do not pay taxes on the contributions until they receive a distribution from the plan when they leave the company; even then they can roll the amount over into an Individual Retirement Account (IRA).

Accounts vest over time, usually following one of two formulas: in the first, vesting starts at two years and completes at six; in the second, participants become 100 percent vested after four years. When employees leave the company, they receive their vested ESOP shares, which the company or the ESOP buys back at an appraised fair market value. ESOP participants must be allowed to vote their allocated shares at least on major issues, such as closing or selling the company, but are not required to be able to vote on other issues, such as choosing the boards.

In the U.S., ESOPs are a kind of employee benefit plan under U.S. retirement law. ESOPs were given a specific statutory framework in 1974. ^[7] ESOPs in the United States are regulated by the Employee Retirement Income Security Act (ERISA) just like other defined contribution and qualified retirement plans.

Like other tax-qualified deferred compensation plans, ESOPs must not discriminate in their operations in favor of highly compensated employees, officers, or owners. In an ESOP, a company sets up an employee benefit trust, which it funds by contributing cash to buy company stock, contributing shares directly, or having the trust borrow money to buy stock, with the company making contributions to the plan to enable it to repay the loan. Generally, at least all full-time employees with a year or more of service are in the plan.

No other nation in the world has laws that sanction an arrangement that is the same as the U.S. ESOP. The ESOP model is tied to the unique U.S. system encouraging private retirement savings plans, and tax policies which reflect that goal.

Most private U.S. companies operating as an ESOP are structured as S corporation ESOPs (S ESOPs). The United States Congress established S ESOPs in 1998, to encourage and expand retirement savings by giving millions more American workers the opportunity to have equity in the companies where they work.

S ESOPs have been credited with providing retirement security, job stability and worker retention, due to the culture, stability and productivity gains associated with employee-ownership. A study of a cross-section of Subchapter S firms with an Employee Stock Ownership Plan shows that S ESOP companies performed better in 2008 compared to non-S ESOP firms, paid their workers higher wages on average than other firms in the same industries, contributed more to their workers’ retirement security, and hired workers when the overall U.S. economy was pitched downward and non-S ESOP employers were cutting jobs.^[8] Scholars estimate that annual contributions to employees of S ESOPs total around $14 billion. ^[9] The net U.S. economic benefit from S ESOP savings, job stability and productivity has been estimated to total $33 billion per year.^[10]

A study conducted by the National Center for Employee Ownership found that S ESOP account balances were three to five times higher on average than 401(k) plans. Median employee account balances for S ESOP accounts were found to be between $75,000 to $100,000, while media account balances for employees in 401(k) and other defined contribution plans ranged from $20,000 to $22,000. ^[11]

A study released in July 2012 found that S corporations with private employee stock ownership plans added jobs over the last decade more quickly than the overall private sector. ^[12] Alex Brill, author of the study and a former advisor to the Simpson-Bowles bipartisan deficit reduction commission, concluded that "The unique strengths of employee ownership drove company gains and jobs in the past decade, while helping insulate S-ESOP businesses from the adverse effects of the recent recession." Brill found that members of Employee-Owned S Corporations of America increased employment by 60 percent over the past decade, versus flat employment in the economy as a whole.^[13]

In a U.S. ESOP, employees do not pay taxes on the contributions until they receive a distribution from the plan when they leave the company. They can roll the amount over into an IRA. There is no requirement that a private sector employer provide retirement savings plans for employees.

Employee ownership appears to increase production and profitability, and improve employees' dedication and sense of ownership.^{[14][15][16][17][18]} The key variable in making it work is a high degree of involvement in work-level decisions (employee teams, for instance). Employee stock ownership can increase the employees' financial risk if the company does poorly,^[19] but the data from ESOPs in the U.S. show that ESOP participants have three times the total retirement assets (including 401(k) plans) as comparable employees in non-ESOP companies and have diversified holdings at least as large.^[20]

Diversification has been cited as an issue, and there are examples to support this view. Employees at companies such as Enron and WorldCom lost much of their retirement savings by over-investing in company stock in their 401(k) plans, though these specific companies were not employee-owned. Enron, Polaroid and United Airlines, all of which had ESOPs when they went bankrupt, were C corporations. Most S corporation ESOPs offer their employees at least one qualified retirement savings plan like a 401(k) in addition to the ESOP, allowing for greater diversification of assets. Studies in Massachusetts, Ohio, and Washington state show that, on average, employees participating in the main form of employee ownership have considerably more in retirement assets than comparable employees in non-ESOP firms. The most comprehensive of the studies, a report on all ESOP firms in Washington state, found that the retirement assets were about three times as great, and the diversified portion of employee retirement plans was about the same as the total retirement assets of comparable employees in equivalent non-ESOP firms. Wages in ESOP firms were also 5 per cent to 12 per cent higher. National data from Joseph Blasi and Douglas Kruse at Rutgers shows that ESOP companies are more successful than comparable firms and, perhaps as a result, were more likely to offer additional diversified retirement plans alongside their ESOPs. The data is also available at www.nceo.org and [1].

In some circumstances, shares in ESOP trusts accrue disproportionately to employees who enrolled earlier. Newer employees at ESOP companies can be left without much opportunity to participate in the program, as a large portion of the shares have already been allocated to longstanding employees.^[21]

Employee ownership in 401(k) plans, however, is more problematic. About 17 per cent of total 401(k) assets are invested in company stock—more in those companies that offer it as an option (although many do not). This may be an excessive concentration in a plan specifically meant to be for retirement security. In contrast, it may not be a serious problem for an ESOP or other options, which are meant as wealth building tools, preferably to exist alongside other plans.

Stock options and similar plans (stock appreciation rights, phantom stock, and restricted stock, primarily) are common in most industrial and some developing countries. Only in the U.S., however, is there a widespread practice of sharing this kind of ownership broadly with employees, mostly (but not entirely) in the technology sector (Whole Foods and Starbucks also do this, for instance). The tax rules for employee ownership vary widely from country to country. Only a few, most notably the U.S., Ireland, and the UK, have significant tax laws to encourage broad-based employee ownership.^[22] In India, employee stock option plans are called "ESOPs”.^[23]

The most celebrated (and studied) case of a multinational corporation based wholly on worker-ownership principles is the Mondragon Cooperative Corporation.^[24] Unlike in the United States, however, Spanish law requires that members of the Mondragon Corporation are registered as self-employed. This differentiates co-operative ownership (in which self-employed owner-members each have one voting share, or shares are controlled by a co-operative legal entity) from employee ownership (where ownership is typically held as a block of shares on behalf of employees using an Employee Benefit Trust, or company rules embed mechanisms for distributing shares to employees and ensuring they remain majority shareholders).^[25][26]

Different forms of employee ownership, and the principles that underlie them,^[27] are strongly associated with the emergence of an international social enterprise movement. Key agents of employee ownership, such as Co-operatives UK and the Employee Ownership Association (EOA), play an active role in promoting employee ownership as a de facto standard for the development of social enterprises.^[28]

Other varieties of employee ownership include:

Direct purchase plans simply allow employees to buy shares in the company with their own, usually after-tax, money. In the U.S. and several foreign countries, there are special tax-qualified plans, however, that allow employees to buy stock either at a discount or with matching shares from the company. For instance, in the U.S., employees can put aside after-tax pay over some period of time (typically 6–12 months) then use the accumulated funds to buy shares at up to a 15% discount at either the price at the time of purchase or the time when they started putting aside the money, whichever is lower. In the U.K. employee purchases can be matched directly by the company.

Stock options give employees the right to buy a number of shares at a price fixed at grant for a defined number of years into the future[2]. Options, and all the plans listed below, can be given to any employee under whatever rules the company creates, with limited exceptions in various countries.

Restricted stock and its close relative restricted stock units give employees the right to acquire or receive shares, by gift or purchase, once certain restrictions, such as working a certain number of years or meeting a performance target, are met.

Phantom stock pays a future cash bonus equal to the value of a certain number of shares.

Stock appreciation rights provide the right to the increase in the value of a designated number of shares, usually paid in cash but occasionally settled in shares (this is called a “stock–settled” SAR).

Worker cooperatives are very different from the above mechanisms. They require members to join. Each worker-member buys a membership interest at a fixed price, or buys a share. Only workers can be members, but cooperatives can hire non-worker-owners. Each member gets one vote.

• List of employee-owned companies
• Louis O. Kelso
• CSG Partners
• Economics of participation
• Timeline of Significant Events in ESOP Development

• Ron Kind, Erik Paulsen (2012), A model for sound retirement, Washington, DC{{citation}}: CS1 maint: location missing publisher (link)
• Alex Brill (2012), An Analysis of the Benefits S ESOPs Provide the U.S. Economy and Workforce (PDF), Washington, DC{{citation}}: CS1 maint: location missing publisher (link)
• Joseph Blasi, Douglas Kruse; Bernstein, Aaron (2003), In the company of owners: The Truth about Stock Options (and why Every Employee Should Have Them), New York, NY: Basic Books, ISBN 9780465007004, OCLC 50479205 63084526 {{citation}}: Check |oclc= value (help)CS1 maint: multiple names: authors list (link)
• Rosen, Corey; Case, John; Staubus, Martin (2005), Equity: Why Employee Ownership is Good for Business, Boston, Mass.: Harvard Business School Press, ISBN 9781591393313, OCLC 57557579{{citation}}: CS1 maint: multiple names: authors list (link)
• Rosen, Corey, Understanding ESOPs, National Center for Employee Ownership, Oakland, CA, 2010, www.nceo.org
• Curl, John (2009) For All The People: Uncovering the Hidden History of Cooperation, Cooperative Movements, and Communalism in America, PM Press, ISBN 978-1-60486-072-6
• Staubus, Martin (2011), "Creating a High-Performing Workplace", Employee Ownership Insights (Summer 2011), The Beyster Institute
• Stumpff, Andrew W. (2009), "Fifty Years of Utopia: The Weird History of the Employee Stock Ownership Plan", Tax Lawyer (Winter 2009), Georgetown University Law School/American Bar Association: 419–432
• Menke, John D.; Buxton, Dickson C. (2010), "The Origin and History of the ESOP and Its Future Role as a Business Succession Tool", Journal of Financial Service Professionals (May 2010), Society of Financial Service Professionals{{citation}}: CS1 maint: multiple names: authors list (link)

• Beyster Institute
• Center on Business and Poverty
• Employee-Owned S Corporations of America
• ESOP Association
• Foundation for Enterprise Development
• The National Center for Employee Ownership
• Rutgers School of Management and Labor Relations
• Vermont Employee Ownership Center
• A Venture of Corporate Professionals