How ESOPs Work

The company sets up a trust fund for employees and contributes either cash to buy company stock, contributes shares directly to the plan, or has the plan borrow money to buy shares. If the plan borrows money, the company makes tax-deductible contributions to the plan to enable it to repay the loan.

These contributions are allocated to individual employee accounts within the trust. A number of different formulas may be used for allocation. The most common is allocation in proportion to compensation, but formulas allocating stock according to years of service, some combination of compensation and years of service, and equally, have all been used. Typically employees might join the plan and begin receiving allocations after completing one year of service with the company, where any year in which an employee works at least 1000 hours is counted as a year of service. Employees pay no tax on the contributions until they receive the stock when they leave or retire from the company.