3817 / What is an Employee Stock Ownership Plan (“ESOP”)?

An Employee Stock Ownership Plan (“ESOP”) is a defined contribution plan and can be either a qualified stock bonus plan or a profit sharing or money purchase pension plan, or any combination.¹ The unique feature of this type of plan that distinguishes it from stock bonus plans is that an ESOP is permitted to purchase employer securities through a loan. A similar purchase under any other plan would be a prohibited transaction.² The loan can be from the employer or another party, such as a bank. Although an ESOP is designed to invest primarily in employer securities, the trustee of the ESOP must make a determination as to whether the purchase of employer securities for the plan is prudent. In Fifth Third Bancorp v. Dudenhoeffer,³ the Supreme Court held that a trustee is not entitled to a presumption of prudence in making this determination.

The IRC specifies that an ESOP must be designed to invest primarily in “qualifying employer securities.”⁴ Qualifying employer securities are shares of common stock issued by the employer (or a member of the same controlled group) that are (1) readily tradable on an established securities market or, in case there is no such readily tradable stock and (2) have a combination of voting power and dividend rights at least equal to the class of common stock having the greatest voting power and the class of common stock having the greatest dividend rights.

Noncallable preferred shares also qualify if they are convertible into stock meeting the requirements of (1) or (2), above, (as appropriate) and if the conversion price is reasonable at the time the shares are acquired by the plan.⁵ The IRS determined that the common stock of a corporation did not constitute employer securities with respect to employees of a partnership owned by the corporation’s subsidiary because a partnership is not a corporate entity. As a result, the employees of the partnership could not participate in the corporation’s ESOP.⁶