Any owner of a successful, privately held, small business will tell you that businesses are fun to build, but that the tax system does not provide many benefits to ownership. Short of selling the stock in their company, outright to a third party, they have few ways to derive tax benefits from ownership while operating the company.

Further, in this age of stock option incentives at public companies, privately held businesses can find themselves at a disadvantage when it comes to attracting qualified employees who are looking for incentives beyond a paycheck.

The answer to both problems may lie in a 1921 law, known as the Industrial Homestead Act, which was designed to broaden the ownership of capital by employees. Then it was called a Stock Bonus Plan, we know it today as an Employee Stock Ownership Plan, or “ESOP.”

The Homestead Act encouraged the development of the nation’s major natural resource—land—by providing that any person could homestead up to 160 acres per person. The law allowed any person who took possession of the land and assumed responsibility for making it productive for a certain period of years would acquire full ownership of this land at the end of that time.

As a result of this legislation, hundreds of thousands of people were able to acquire capital and to become financially independent. The ESOP is an extension of this logic into the industrialized economy we know today.

ESOPs have evolved from 1952 legislation that allowed them to be set up as tax-exempt trusts, designed to enable employees to own part or all of the company for which they work, without investing their own funds.

When a company establishes an ESOP, the company makes a tax-deductible contribution to the trust, which may purchase company stock from shareholders. The employee participants hold beneficial ownership interests in the assets of the trust and are the beneficiaries. Normally the employer, or major shareholders, are the trustee(s) of the trust, and retain all rights to vote the stock for company control purposes.

Each year the value of the stock must be determined by an independent appraisal of the business. If the business does well and appreciates, this appreciation increases the value of the stock held in the trust, and correspondingly increases the value of each participant’s share.

When an employee leaves the company, their ownership interest is distributed from the trust to them as cash. This distribution is treated as any other qualified plan distribution and may be rolled over into an IRA in order to defer further taxation.

Employees benefit because they can now participate in the appreciation in value of the company that results from their efforts. As with any other pension plan, an ESOP provides a store of future wealth for retirement.

Ownership benefits because stock they sell is taxed at capital gains rates instead of ordinary income rates. They have a ready market for their ownership interests, without giving up control of the company. Best of all, they have a way to reward the employees who make the business a success, in a tax-efficient fashion.