What is an employee stock ownership plan?

There are several rationales for employee-owned corporations. First, there are substantial tax benefits for employee ownership companies. Employee stock ownership plans (ESOPs) are set up by companies as a kind of employee benefit trust. An ESOP is a type of employee benefit plan designed to invest primarily in employer stock. To establish an ESOP, 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 25% 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% of the payroll of plan participants; interest is always deductible. Dividends can be paid to the ESOP to increase this amount over 25%. 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% ESOPs pay no federal income tax. 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 IRA.