The IRS authorized stock bonus plans in 1926. Some of the early plan companies included Sears, J. C. Penney and Proctor & Gamble. Thirty years later, an IRS Ruling allowed stock bonus plans to borrow funds to purchase company stock. With this ruling Peninsula Newspapers created the very first IRS qualified ESOP. Within the next decade only about two dozen were in force, but from 1968 to 1971 about 50 new ESOPs were created each year. Then, in 1974, the ESOP became big news.

On September 2, Congress passed the Employee Retirement Income Security Act (ERISA) partly because the Dow Jones Average languished in the 500s. There was no venture capital and no mergers or acquisitions. Small businesses found it difficult, if not impossible, to borrow money from their banks. The economy was basically stalled.

Congress endorsed ESOPs because they:

  • Minimized taxes for smaller, struggling companies.
  • Slowed inflation (Employees often accepted less pay in return for equity).
  • Motivated employees and increased productivity.
  • Generated capital.
  • Prevented some unionization and cut the frequency of strikes.

Congress continued to encourage ESOPs by providing better tax incentives for companies by adding enhancements in 1976, 1978, 1982 and 1984. Since 1974, more than 24 different laws passed, improving and supporting ESOPs. A significant change made in 1998, allows sub-chapter corporations to implement ESOPs. “S” Corporation ESOPs are extraordinary opportunities. Congress encourages them to set up ESOP plans that cover most, if not all, full-time employees with at least one year of employment. In some cases the company becomes 100% owned by their ESOP, free from state and federal income tax. These tax incentives are by design -- not loopholes. This major change went somewhat unnoticed because, at the time, the economy was robust. NYSE and NASDAQ performance was off the charts; millions of dollars in venture capital (VC) money was readily available; “merger- mania” was running wild and the announcements of new and successful IPOs seemed to be occurring non-stop.

But now that boom is over and many of the conditions present in 1974 have returned with a vengeance. Real unemployment is up, VC money is tight, IPOs are virtually non-existent, mergers and acquisitions are few and far between and businesses find it more difficult to borrow money. Consequently, retiring business owners struggle to find qualified buyers. Nonetheless, the ESOP remains an extremely powerful financing tool, still the best tool for today’s business owner seeking a way to unlock equity.