The idea was companies would borrow money through the ESOP, which would purchase newly issued shares. The company would use the proceeds from the purchase for capital growth and pay the loan back through the ESOP with pretax dollars. The number of shares would increase dilution for the existing owners, but the employees would get a new benefit plan, the company would get a tax deduction, and hopefully the new employee owners would help the company grow enough to offset the dilution.
It turned out that few companies used ESOPs this way. Instead, ESOPs were used primarily in closely held companies for business transition. From 1984 onward, tax incentives focused mostly on this application of ESOPs.
It’s useful to look at the evolution of ESOPs since those early days in three sectors: public companies, the relatively brief phase when ESOPs were being used to rescue failing companies, and closely held companies where the ESOP is used for business transition.
Early advocates for ESOPs focused on getting public companies to adopt these plans.
In 1978, Congress passed a law that provided a tax credit based on a company’s qualifying investments in new capital, the so-called Tax Reduction Act Stock Ownership Plan.
That was replaced in 1982 by the Payroll-Based Stock Ownership Plan, which provided a credit up to 1.5% of a company’s payroll for contributions of stock to an ESOP. The idea was that by paying companies directly to share ownership with employees, companies would see the benefit and contribute more to make these ownership plans more meaningful. The NCEO’s first research project was to assess whether this was actually happening. It turned out almost no companies were expanding ESOPs beyond what the credits provided.
At their peak there were about 800 ESOPs in public companies —the vast majority of which owned under 5% of the stock and were funded by these tax credits. When the tax credits were eliminated in 1984, many companies stopped funding these plans, although most did not terminate them.
The 1984 bill, however, also contained a provision that allowed lenders to companies with ESOPs to exclude 50% of the income from these loans from their tax obligation. Interest rates at the time were quite high, with prime over 10% and business loans even higher. A 50% exclusion translated into an interest rate reduction of a few points on these loans.
The result of this was an aggressive campaign by banks to promote ESOP lending. There were full-page ads in the Wall Street Journal and other papers promoting the idea. At its peak, $70 billion ($200 billion in today’s dollars) was loaned to ESOPs.
Most of the public companies that borrowed money to fund their ESOPs were purchasing shares to put in a suspense account to be released over time. These companies were already contributing cash to match employee 401(k) deferrals. Now these companies used the release of the shares from the ESOP loan instead of cash as a match.
In many companies, the goal was that, as the share price of the released shares went up, the company effectively could pay for part of its match in share price appreciation rather than cash. Some companies also borrowed significant amounts to fund ESOPs to help fend off hostile takeovers, albeit this strategy probably was ineffective because of fiduciary rules and often led to litigation.
In 1989, concerns about how ESOPs were being used, as well as the tax cost of the incentive, led Congress to limit its application to ESOPs that bought 50% or more of the shares. In 1993, the incentive was eliminated entirely, although by then lower interest rates meant that the exclusion was less significant.
Throughout the 1990s and into the early 2000s, some public companies continued to use ESOPs as a significant part of their 401(k) plans. The recession of the late 1990s, followed by accounting scandals at WorldCom, Enron, and other companies with a lot of employer stock in their plans, led to a wave of litigation over the prudence of employer stock in these retirement plans.
That resulted in a gradual reduction in the number of companies using ESOPs this way, as well as a reduction in the number of employees who wanted to invest their 401(k) assets in company stock. At its peak in the early 2000s, about 17% of retirement assets were held in employer stock in companies that offered employer stock as a match or a deferral option. That number has dropped below 7% today.
While the importance of ESOPs in public companies has diminished, as of 2021, there were 560 public company ESOPs with $172 billion in company stock held by these plans for about 12.3 million participants, or about $14,000 per participant. Most of these plans are part of a 401(k) plan, and the assets in cash are far larger.
Almost all ESOPs created during the 1980s were being used for business transition, but a small highly publicized number of companies were using ESOPs to help them from going out of business, most notably at Weirton Steel in Weirton, WV, a company that at the time had 7,000 employees; Rath Packing, a meatpacking company in Iowa with 3,000 employees; and Okonite, a cable manufacturer in New Jersey with 1,900 employees.
Several smaller steel companies were bought by employees, as well as a handful of companies in other businesses, mostly manufacturing. These buyouts had a mixed track record. A few ended up failing quickly; some, like Okonite, went on to prosper and remain ESOP companies. Most stayed in business for several years, sometimes being sold to another company or at least retaining jobs and pensions longer than would have otherwise been the case. Many of the buyouts were union-led, especially in the steel industry.
Although these ESOPs never accounted for more than 1% of all ESOP transactions, they received a disproportionate amount of press coverage, including a front-page story in the Wall Street Journal titled “The Grapes of Rath,” about the difficulties the ESOP had at Rath Packing. We told the reporter on that story this use of ESOPs was rare, but the story instead said this was the norm. We asked the reporter about this, and she said it made a more interesting story that way.
Aside from these employee-led purchases, a number of companies sought wage concessions from employees in return for partial ESOPs. This was especially common in the steel, airline, and trucking industries. United Airlines in 1995 was the last major company to do this. Its ESOP was set to expire after five years, which coincided with United and most other major airlines declaring bankruptcy during the late 1990s early 2000s recession. The use of employee ownership plans to save failing companies has virtually disappeared in the last 25 years.
In the mid-to-late 1980s, some major investment groups decided to use ESOPs to sell companies they had purchased. The most important of these was WesRay, an investment firm that was cofounded by former Secretary of the Treasury William Simon. WesRay sold Avis to an ESOP in 1987 for $750 million. The company advertised being employee-owned and set up an effective employee involvement system that helped the company prosper. The company was sold nine years later for three times what the ESOP had paid for it. WesRay also sold Simmons Mattress to an ESOP, but that did not work out well. The company ran into financial problems and ended up in litigation over the ESOP. (The case was ultimately settled.)
In several other investor-led transactions, the ESOP received a substantial minority interest. Some of these were at major US companies, such as Dan River, Burlington Industries, Raymond International, Scott & Fetzer, and Cone Mills. The model used for allocating shares between the ESOP and the investors in these transactions was highly controversial and led to litigation. Many of the deals were led by Kelso & Company, the investment banking firm Louis Kelso founded, but was no longer involved in. The ESOPs at these companies were eventually terminated and the investor groups decided ESOPs were not a model they wanted to pursue.
The much more common and conventional use of ESOPs was in closely-held companies owned by individuals, families, or partners. These companies ranged from as small as 20 or even fewer employees to companies with thousands of employees. Most are in the range of 50 to 500 employees. These companies tended to be mature, stable, and profitable companies whose owners had a strong commitment to the legacy of the company and to the employees.
The growth of the use of ESOPs for this purpose was fueled in part by the 1984 tax law that allowed sellers to ESOPs to defer taxation on the gain made from the sale to the ESOP. Ironically, that tax incentive was a last-minute addition to the 1984 tax bill and was not seen at the time as one of the more important ESOP incentives. The use of ESOPs for business transition in closely held companies remains the dominant application today.
The ESOPs in these companies often started with partial ownership and gradually acquired majority ownership in the company. But until the late 1990s, 100% ESOPs were still relatively uncommon. In 1997, as part of a reform for ownership rules and S corporations, ESOP trusts were allowed to own S stock for the first time and, unlike other nontaxable entities, were not required to pay unrelated business income tax on their share of company profits. This change in the law had a dramatic impact on ESOPs.
Now most ESOP companies either are or will become 100% employee-owned S companies. A major result of this is that more and more ESOP companies want to stay ESOP owned over the long term. Partly because of this, these companies are paying a lot more attention to creating and sustaining the kinds of cultures that make an ESOP successful.
While ESOPs have grown substantially over the years and have provided hundreds of billions of dollars in benefits to millions of participants, their penetration of the market is far less than advocates would like. For closely held companies, the main obstacles remain a lack of information among potential sellers to ESOPs about how these plans work and a reluctance of some sellers to sell to an ESOP when the financing involves a seller note they will be paid over time
The 2022 WORK Act could help resolve the outreach problem by providing federal funding for state employee ownership programs, but it is not clear if Congress will appropriate the funds for this law.
There are also efforts to provide more federal funding support for ESOP transactions so sellers could receive more of their money upfront, but these would require legislative action. Meanwhile, many mature ESOP companies are now actively seeking to buy other companies, and most growth in ESOP participation is coming from this promising trend.
For larger companies, including public companies and companies owned by investor groups, greater ESOP penetration most likely depends on the creation of additional incentives for these companies to set up partial ESOPs. There is an effort underway to try to create these incentives, but passing any new tax incentives is difficult.