An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan governed by ERISA and IRC §401(a) that invests primarily in employer stock. Unlike stock options, employees do not purchase the stock; instead, the company contributes shares or cash to an ESOP trust, which allocates shares to individual employee accounts based on compensation. Shares vest over time and are bought back by the company at fair market value when the employee leaves.
For business owners, an ESOP serves as a powerful succession planning tool. Under IRC §1042, an owner who sells stock to an ESOP that owns at least 30% of the company can defer capital gains tax indefinitely by reinvesting the sale proceeds in qualified replacement property (such as domestic corporate bonds or equities). Furthermore, if an ESOP owns 100% of an S corporation, the company’s earnings are completely exempt from federal income tax, as the sole shareholder is a tax-exempt trust.