Definition
An employee stock ownership plan is a defined contribution plan, described in IRC section 4975(e)(7), that is designed to invest primarily in qualifying employer securities. A leveraged ESOP borrows, directly or from the company, to buy shares, and the company's contributions repay the loan. Shares are released to participant accounts as the loan is paid. For stock that is not readily tradable, IRC section 401(a)(28)(C) requires valuation by an independent appraiser. Qualified participants who are 55 with 10 years of participation have diversification rights.
Why it matters in an audit or review
Auditors of the plan test the independent valuation, the loan terms, allocation of released shares, and repurchase obligations. The sponsor's statements follow ASC 718-40: compensation cost is the fair value of shares committed to be released in the period, and unearned shares are a reduction of equity. ESOP transactions raise party-in-interest and prohibited transaction questions.
Example
Illustrative: an ESOP buys 10,000 shares at $50 with a $500,000 loan, and 1,000 shares are released this year when $50,000 of principal is paid. If fair value of the shares committed to be released averages $60, the company records $60,000 of compensation cost.
Common mistakes
- Using an outdated valuation to measure compensation cost.
- Ignoring the repurchase obligation for shares distributed to departing participants.
Sources
- IRC section 4975(e)(7), definition of employee stock ownership plan: https://www.law.cornell.edu/uscode/text/26/4975
- IRC section 401(a)(28), independent appraisal and diversification: https://www.law.cornell.edu/uscode/text/26/401
- FASB ASC 718-40, Employee Stock Ownership Plans
Definitions paraphrase AICPA and FASB guidance; read the standard itself before relying on a requirement. Example figures are illustrative. This page is guidance, not professional advice. Report an error