Stock Plans

Stock plans differ from profit-sharing plans primarily in the way benefits are distributed--in the form of a company's securities rather than in cash. The more generic type, known as a stock bonus plan, is subject to the same rules as other deferred profit-sharing plans but must allow participants to demand payment in the form of securities from the sponsoring employer.⁽¹⁾ Tax law allows contribution levels either to be linked to profits or simply to be "substantial and recurring." Employee stock ownership plans (ESOPs) are a special type of stock plan that may also have some features of money purchase plans. ESOPs are funded entirely by the sponsoring employer and invest primarily in the company's stock. If certain rules are followed, employers that operate ESOPs receive tax treatment that is more generous than that available to other qualified plans.

An advantage of both types of stock plan is that they give employees a direct interest in the employer's profitability, just as true deferred profit-sharing plans do. Stock bonus plans are particularly attractive because they enable employers to retain more liquid assets than can be retained under profit-sharing plans that must be distributed in cash. That advantage is only temporary, however. Once participants begin retiring and redeeming their shares of stock, the company must either buy the shares back or allow their sale on the open market, which may apply downward pressure on the price.

ESOPs also enhance cash flow in the short term, but they have certain advantages that other stock plans do not share. Unlike other types of qualified plans, for instance, ESOPs can borrow money. They also receive special tax advantages: the company may deduct dividends paid on shares owned by the ESOP, and owners who sell 30 percent or more of the company's stock to an ESOP can defer capital gains on the sale by rolling the proceeds over into the securities of other domestic corporations. On the downside, establishing an ESOP involves higher fixed costs than those associated with establishing other types of plans.

Although the number of ESOPs is larger than the number of stock bonus plans, it is still relatively small: ESOPs cover only 3 percent of the employees of medium-sized and large establishments and just 1 percent of employees of small establishments. The rarity of stock plans being used as general employee benefits may reflect several factors, such as a reluctance to blur the distinction between labor and management or a desire to limit future claims on the company as employees retire. In recent years, ESOPs have attracted criticism because their reliance on the sponsoring company's stock can hinder the ability of employees to diversify their retirement portfolios.