Understanding Employee Stock Ownership Plans

An employee stock ownership plan (ESOP) is a tax-qualified defined contribution plan that allows employees to become owners of their employer’s stock. In fact, stock ownership is the whole purpose of ESOPs — they’re put into place to encourage employees to participate in corporate ownership. An ESOP is the only employee benefit plan that’s required by law to invest primarily in the stock of the sponsoring employer.

ESOPs may be used by corporations to raise capital for the corporation or, in the case of a privately held company, to purchase stock from a shareholder. Tax advantages of the ESOP make the borrowing of funds less expensive through the ESOP than if the corporation borrowed the funds directly from a bank.

One potential danger of an ESOP for plan participants is the lack of diversification of the investments, because at least 50 percent of the plan’s assets is required to be invested in stock of the sponsoring employer. It’s never a good idea to have a majority of your assets in any particular investment, but it can be particularly devastating when that one particular investment is in the stock of your employer. In such a situation, the employer’s failure can cost you not only your job but your retirement savings as well. Other downsides for the participants can include the following:

• Employee securities can be improperly valued.
• Employee stock can be improperly allocated to individual participant accounts.
• Voting rights may not be provided to plan participants.
• The employer’s loans aren’t primarily in the interests of plan participants.
• Fraud, embezzlement, theft, or other criminal actions can occur.