Thinking about sharing ownership with your team, but not sure where to start? Employee stock ownership plans (ESOPs) are a well-known way for business owners to reward employees and build loyalty. But this type of employee share ownership plan is not always the best option for small business owners.
This guide answers the big question: how does an ESOP work? We'll cover everything involved in setting one up and maintaining it over time. Jump to the end and we'll show you why phantom stock plans might be a better fit for most small businesses.
What is an ESOP?
Let's start with the basics: what is an employee stock ownership plan? An ESOP is a benefit for employees in the form of company stock. Note that this is very different from an employee stock option plan (ESO), which does not provide ownership. There are many reasons companies implement ESOPs (see Benefits of ESOPs section below). One of the most important things is that these plans improve employee engagement by aligning owner and employee incentives. At its core, an ESOP is a way for employees to own a stake in the company they work for, creating a powerful sense of partnership and commitment between them as workers and their employers as shareholders.
How Does an ESOP Work for Owners?
For owners, an ESOP offers a way to sell all or part of the business to employees, often with significant tax advantages and additional ESOP benefits to owner. It can be a powerful succession tool, letting owners exit gradually while keeping the company independent and rewarding the team that helped build it. Owners can structure the sale to meet their financial goals, and the transition can boost morale and loyalty across the company.
How Does an ESOP Work for Employees?
For employees, an ESOP means they receive shares in the company as part of their compensation—without having to buy them. Over time, as the company grows and becomes more valuable, so do the shares in their ESOP account. When employees leave or retire, they can cash out their shares and receive a payout based on the current value of the company. This gives employees a real financial stake in the business and a direct reward for helping it succeed.
History of Employee Stock Ownership Plans
The first ESOP was created in 1956 by a lawyer and economist named Louis Kelso as a succession planning tool. At the time, the founders of Peninsula Newspapers were looking to transition ownership of their company to their most trusted employees.
Kelso structured the ESOP with a vision in mind: employees are the most logical buyers (and future owners) of most businesses, since they know the companies they work at better than anyone else. The plan was successfully implemented, and Peninsula Newspapers was quite successful for the next quarter century, paying out millions of dollars to the ESOP’s participants.
Employee stock ownership plans didn’t become more commonplace in the United States until the 1980s. In an attempt to stimulate the economy and encourage owners to pass the torch to future generations, specific provisions were added to the Tax Reform Act of 1984 that made ESOPs even more beneficial than they were before. Two of them are still in effect today:
- Deferred capital gains tax: this allows owners to make their stock liquid and have tax favorable treatment.
- Deductible dividends: this enables an ESOP to purchase large shares of a given company.
How Does an ESOP Work?
Here’s a step-by-step look at how an ESOP works, from setting up the trust to cashing out when someone leaves or retires.
Setting Up an ESOP Trust and Appointing a Trustee
The foundation of any Employee Stock Ownership Plan (ESOP) is the creation of a trust. This trust is a legal entity that holds company shares on behalf of employees. A trustee—who acts as a fiduciary—is appointed to oversee the trust and ensure it operates in the best interests of plan participants.
Funding the ESOP: Contributions, Share Issuance, or Leveraged Buyouts
There are several ways to fund an ESOP trust. Most commonly, the company makes contributions of newly issued shares or cash. The ESOP can use cash to purchase existing shares from current owners. In some cases, the ESOP borrows money (a leveraged ESOP) to buy shares, with the company repaying the loan over time.
Annual Share Allocation to Employees
Each year, employees receive an allocation of ESOP shares. The number of shares granted is typically based on factors such as salary, years of service, or job title. Employees do not need to purchase these shares; instead, they are awarded as part of the overall compensation package.
ESOP Vesting Schedules and Participant Statements
ESOP shares are subject to vesting, which means employees earn ownership rights over time. Companies may use a cliff vesting schedule (full ownership after a set period) or a graded vesting schedule (ownership increases gradually each year). Participants receive annual statements detailing their ESOP account balance and vested shares.
Annual Valuation of ESOP Shares
For private companies, an independent appraiser conducts an annual valuation to determine the fair market value of ESOP shares. This ensures that employees receive an accurate reflection of the company’s worth in their account statements and eventual payouts.
Distributions and Cash-Out Rules When Employees Leave or Retire
When employees leave the company or retire, they are entitled to receive the value of their vested ESOP shares. The company typically buys back the shares at their current appraised value, and distributions are made according to the plan’s rules and timeline. This provides employees with a meaningful financial benefit as they transition out of the company.
ESOP Eligibility & Participation
Most ESOPs are designed to include a broad base of employees, not just executives or owners. Federal regulations require that ESOPs must satisfy IRS coverage/nondiscrimination tests to ensure broad participation. Typical eligibility criteria include reaching a minimum age (often 21) and completing a certain period of service, such as one year of employment.
How Much Do Employees Receive? Allocation Formulas Explained
The amount of ESOP shares each employee receives is usually determined by a formula based on salary, years of service, or a combination of both. This approach ensures that allocations are fair and proportional to each employee’s contributions to the company. The more years an employee works and the higher their compensation, the larger their share allocation tends to be.
Coverage, Nondiscrimination, and Growth Over Time
To comply with IRS rules, ESOPs must meet strict coverage and nondiscrimination requirements, meaning benefits cannot favor only highly paid employees. As employees continue to work and the company grows, their ESOP accounts accumulate more shares and increase in value. Over time, this growth can represent a significant retirement benefit, aligning employee interests with the long-term success of the business.
ESOP Taxes
Understanding the tax implications of an ESOP is essential for both business owners and employees. ESOPs offer unique tax advantages that can benefit companies and participants alike.
ESOP Taxes for Companies
Companies can deduct contributions made to the ESOP, whether in the form of cash or newly issued shares. For leveraged ESOPs, both the interest and principal payments on loans used to buy company stock are generally tax-deductible, providing significant tax savings and improving cash flow.
ESOP Taxes for Employees
Employees are not taxed on ESOP shares while they are held in the plan. Taxes are only due when distributions are made, typically at retirement or separation from the company. These distributions are taxed as ordinary income, and early withdrawals may be subject to additional penalties, similar to other qualified retirement plans.
ESOP Costs, Compliance & Ongoing Admin
Establishing and maintaining an ESOP requires careful attention to regulatory compliance and ongoing administration. While ESOPs offer powerful benefits, business owners should be aware of the responsibilities and costs involved.
ESOP Compliance and Regulatory Requirements
ESOPs are governed by the Employee Retirement Income Security Act (ERISA), which sets strict standards for plan operation and fiduciary responsibility. Companies must file Form 5500 annually with the Department of Labor to report plan activity and compliance. Private companies are also required to obtain an independent annual valuation of their shares to ensure accurate reporting and fair participant payouts. If the ESOP has more than 100 participants, an annual audit by an independent CPA is required.
Trustees and Ongoing Administration
A trustee—either internal or external—must be appointed to oversee the ESOP and act in the best interests of plan participants. Ongoing administration includes maintaining participant records, managing distributions, and ensuring compliance with all regulatory requirements.
ESOP Setup Timeline and Total Cost of Ownership
Setting up an ESOP typically takes several months, from initial feasibility studies and plan design to legal documentation and trust formation. The total cost of ownership includes one-time setup expenses, annual valuation fees, administrative costs, and potential audit fees for larger plans. While these costs are significant, many business owners find the long-term benefits of employee ownership and tax advantages outweigh the investment.
Understanding ESOP Repurchase Obligation and Cash-Flow Planning
Repurchase obligation refers to the company’s responsibility to buy back ESOP shares from employees when they retire or leave the company. This obligation is crucial because it impacts the company’s future cash flow and financial planning. Failing to plan for repurchase can strain resources and jeopardize the ESOP’s sustainability.
Companies typically fund repurchase obligations by setting aside cash reserves, making installment payments, or using a combination of both strategies to manage the impact on cash flow.
For example, if three employees retire in a year and each holds $100,000 in ESOP shares, the company must be prepared to pay out $300,000. If the plan allows distributions over five years, that means the company needs to budget for $60,000 per year. Careful forecasting and funding strategies ensure the company can meet these obligations without disrupting operations.
Benefits of ESOPs
The most recent data on ESOPs is from 2020 and shows that there are nearly 6,500 plans with 14 million participants in the United States. What are the primary benefits that make ESOPs such an appealing tool for business owners?
Employee retention
Employee stock ownership plans are a great way to keep your best employees. In fact, ESOP companies are 3 – 4 times more likely to retain staff than non-ESOP companies. When businesses implement ESOPs, they’re giving their employees a strong financial incentive to stick around. For employees thinking about their long-term plans, knowing they have a retirement plan in the form of an ESOP incentive plan can be very desirable.
Employee motivation
ESOPs align employee-employer incentives. ESOP companies grow faster than non ESOP companies, and have increased productivity. Knowing that they have a true stake in their employer’s company can push employees to be as productive as possible, making the business more valuable, which results in a better result for everyone involved when it comes to a future cash payout.
Market competitive
While businesses expect 2024 to be a bit more company-friendly when it comes to hiring compared to the previous three years, the labor market is still tight and business owners acknowledge that employees still hold a strong position in the market. Implementing a benefits plan like an employee stock ownership plan can help businesses – especially smaller ones that struggle to compete against larger companies – stand out as they look to hire.
Tax advantages
In addition to the 1980s ESOP tax benefits mentioned at the start of this blog post (deferred capital gains tax and deductible dividends) that are still in effect today, there are several other newer tax advantages that have been added over the years, including tax deferrals for employees, retirement rollover flexibility, and tax deductibility for companies (which results in extra cash flow).
Succession planning
This is perhaps the most interesting and important long-term benefit to employers. Let’s revisit Louis Kelso and the first employee stock ownership plan, which was created first and foremost as a succession planning tool. Prior to this, if a business owner wanted to retire, they only had a few options:
- Selling a fraction of the business to employees and enabling a stock redemption plan for the rest: This allows for an owner cashout, but the debt has to be repaid with after tax dollars, which usually means the debt lingers for many years.
- Selling to a competitor: This can erase an owner’s legacy, not to mention the company identity once it is absorbed into the buyer’s portfolio. Oftentimes, a buyer will pay in both cash and earnout, requiring owners to stay on for years when they are ready to retire.
- Selling to a venture capital firm: Appealing on the surface due to the high dollar amount VCs are often willing to pay for a business, it can be another story after the deal is closed. Layoffs should be expected, along with a shift in focus from customer value to raw numbers, and various cost-cutting measures.
ESOPs are a much more flexible, business and employee-friendly way to successfully cash out and pass a business on to the next generation.
Challenges with employee stock ownership plans
ESOPs are not without their challenges. Here are some of the biggest problems with them.
Education and Implementation
The first hurdle is understanding the ins and outs of ESOPs as an owner, and explaining them to employees. ESOPs can be complicated to implement, and require legal and financial guidance when doing so. One example of an initial hurdle is the company and share valuation process, which must be done by a third party.
Not easily available to very small businesses
ESOPs should only be considered by firms with a minimum of roughly 20 employees, though that is more of a guiding principle than a hard rule. This is to ensure that the costs of implementing and maintaining an ESOP are sustainable, that there is sufficient cash flow, and that the business is able to maintain regulatory compliance. The legal fees, annual valuations, and compliance requirements don’t shrink just because your team is small—they hit just as hard. For many small businesses, the cash flow and admin burden make ESOPs feel out of reach, no matter how much you want to share ownership with your people.
Reduced diversification
For both owners and employees, having a large portion of retirement savings tied up in one asset (in this case, an ESOP linked to one business), can be risky if the company doesn’t perform well. It’s important to consider individual financial situations and consult with appropriate experts.
Phantom Stock: The Best ESOP Alternative for Small Businesses
Phantom stock is a popular alternative to ESOPs for small businesses that want to reward and retain key employees without the complexity of actual stock ownership. With phantom stock, employees don’t receive real shares—instead, they get a promise of future cash payouts based on the company’s value, just like they would if they owned stock.
Here’s how it works: The company grants “phantom” shares to employees. Over time, these shares grow in value as the business grows. When employees hit certain milestones, retire, or leave the company, they receive a cash payment equal to the value of their phantom shares. There’s no need to transfer real equity, set up a trust, or deal with the heavy compliance requirements that come with an ESOP.
For most small businesses, phantom stock is easier to set up, less expensive to administer, and more flexible than a traditional ESOP. There’s no need for annual valuations, complex legal filings, or worrying about repurchase obligations. You get the benefits of employee ownership—alignment, retention, and motivation—without the headaches.
That’s why we built Reins. We make it easy for small businesses to launch and manage phantom stock plans in just a few clicks. With Reins, you can create a custom plan, grant awards, and track everything from one simple dashboard—no lawyers or spreadsheets required. If you want the power of employee ownership without the hassle, phantom stock with Reins is the way to go. Book a call and we'll show you how.
ESOPs vs Phantom Stock
This table shows the key differences between ESOPs and phantom stocks.
Case Study: How Wes Carver Electric Used Phantom Stock to Motivate Their Team
Wes Carver Electric, a family-owned electrical contractor in Pennsylvania, wanted to reward their team with something more than just a paycheck. But the idea of setting up equity or phantom stock felt overwhelming—full of legal jargon, high stakes, and months of uncertainty. Wes, the owner, worried about making the wrong move and how it might affect both his business and his people.
That’s when Wes turned to Reins. Instead of a confusing, six-month legal process, Reins made it simple and clear. Wes got step-by-step guidance, answers to every question, and the flexibility to design a plan that fit both long-time and newer employees. The process replaced confusion and fear with confidence and momentum.
After launching the Reins-powered phantom stock plan, Wes saw an immediate boost in team motivation and alignment. Employees understood what they were working toward and felt invested in the company’s future. For Wes, the biggest win was knowing he’d made the right decision for his business and his team—without the stress and complexity he’d feared.
If you’re a small business owner thinking about sharing ownership, Wes’s story shows how phantom stock with Reins can help you keep your best people and build a legacy, all without the ESOP headaches. Book a call and we'll show you how.
