An employee stock ownership plan (ESOP) is an employee benefit plan that allows employees of a company to own stock in that company. 

How does an ESOP work?

• The ESOP operates through a trust, established by the employer, which accepts contributions from the employer to purchase the company’s stock.

• An ESOP is required by law to invest in the stock of the sponsoring company. 

• The employer’s contributions are distributed to individual employee accounts within the trust.

• The amount of stock each individual receives may vary according to salary, service and position.

• Employees can ‘cash out’ after vesting in the program or when they leave the company. Vesting rules specify how long employees should participate in the ESOP before the benefits become irrevocable. Those who leave a job before the vesting requirements are complete lose all or part of the benefits.

• Employees receive the vested portion of their accounts after termination, disability, death, or retirement. These distributions may be made in a lump sum or in installments.

Advantages of an ESOP

1. Employees don’t need to buy shares. The company contributes its own shares to the plan or provides cash to buy its own stock.

2. The company can use the ESOP plan to borrow money to buy stock, with the company repaying the loan. ESOP is unique among qualified employee benefit plans in its ability to borrow money.

3. Employees are not taxed on their share of the ESOP assets. They are not taxed until they receive distributions. But dividends directly paid to employees on the stock allocated to their ESOP accounts are fully taxable. More details can be found here.

4. Contributions to the ESOP are tax deductible for the company. It can also increase its cash flow and net worth by issuing fresh stock to its ESOP.

Disadvantages of an ESOP

1. If the stock’s value rises substantially, the ESOP or the company may not have sufficient funds to buy back the stock when employees retire.

2. If the value of the company declines, the ESOP could be less attractive than a profit sharing plan. If the company collapses, the employees will lose their benefits.

Remember that ESOP in the U.S. does not mean 'Employee Stock Option Plan' and is not a generic term for an employee stock plan.