Even though the employment market is flooded with unemployed top talent, smart companies need to always be thinking about the most effective ways to retain their best employees.

Perhaps one of the most powerful employee engagement tools is an employee stock ownership plan (ESOP). “What greater way to motivate each and every [employee] than by giving them all a little piece of the pie,” says James Sinclair, the principal of OnSite Consulting, a nationwide consultant to the hospitality industry. An ESOP “motivates employees, improves firm performance, fosters innovation, and promotes sound financial health,” says Sinclair. Indeed, studies show that employee motivation and productivity increase in companies with ESOPs.

By definition, an ESOP is a qualified defined-contribution employee benefit plan that invests primarily in the stock of the employer company and allows employees to become partial owners of the business. In the United States, more than 11,000 companies — from Fortune 500 firms to small, private types — have implemented an ESOP. That translates to an estimated 8 million employees who own stock in their companies through an ESOP. And according to Gary Young, a corporate attorney and advisor to small businesses on ESOP issues, the appeal of ESOPs for employees goes beyond participation in company ownership. “Like a pilot in a plane, passengers take some comfort in the fact that the pilot will share in the same fate as they will,” he says.

But using ESOPs as an employee engagement tool is often not the primary motivator for most business owners. The real motivation? Tax advantages. “ESOPs give [business owners] the most tax-favored option that the tax code provides anyone,” says Young. An ESOP provides a tax-advantaged vehicle to create liquidity, and a ready market for company shares so that the owner can take some cash out of the business. One of the potential tax advantages is that an entrepreneur who sells company stock with favorable capital gains treatment can possibly defer recognition of that gain indefinitely or altogether, says Young.

There are two types of ESOPs: leveraged and non-leveraged. Companies can make tax-deductible cash contributions to the ESOP to purchase stock or have the ESOP borrow money to buy the shares. Under a leveraged ESOP, an ESOP obtains a loan from a bank, usually with a company guarantee. The ESOP then uses the loan proceeds to buy stock from the company and/or existing shareholders, says David Johnson, an attorney with Turner Padget Graham & Laney in Florence, South Carolina. The company makes annual tax-deductible contributions of cash to the ESOP, which in turn repays the bank. With a non-leveraged ESOP, the company makes annual contributions to the trust either in the form of stock or in cash that is then used to buy shareholder stock.

But ESOPs aren’t for every company. The company must be either an S or C corporation — LLCs, partnerships and sole proprietorships can’t implement them. Expert opinion varies on the minimum size of a company — in terms of number of employees and valuation — that can benefit from an ESOP. Estimates for a minimum value range from $5 million to $10 million, while at least 30 employees are recommended as a minimum workforce. Because companies can make an annual tax-deductible contribution of up to 25 percent of compensation of covered employees in ESOPs, such plans don’t make sense for companies with a low number of employees or low payroll. “If you put the necessary contributions on the back of too few people, then the obligation to cover the debt service becomes too onerous for those in the plans,” says Young.

Also, due to the regular and ongoing contributions that must be made to the plans, ESOPs are best for companies that are producing a lot of steady income. “Such an obligation could be an extra burden in lean years as an increase to expenses,” says Johnson. However, he adds that if a company needs to ease the burden on its cash flow, ESOP contributions can also be made in stock.

Another pitfall: the ESOP repurchase obligation. Closely held companies with an ESOP have a legal obligation to offer to repurchase shares that are distributed to plan participants, says Johnson. The company must also offer to allow those participants who are 55 or older and have 10 years of participation in the plan to diversify out of the company stock. Finally, there can be concern from current shareholders about the dilution of their ownership through continuing stock contributions to an ESOP.

Business owners also need to think in terms of startup and ongoing costs. The process isn’t cheap. Startup costs can run between $60,000 and $100,000, and there will be ongoing legal and consulting fees, annual stock appraisal fees, and record-keeping costs.

To be sure, the advantages of an ESOP are many, but it’s imperative to seek expert advice to find out if the opportunity is right for your company.

Toddi Gutner is an award-winning journalist, writer and editor and currently is a contributing writer covering career and management issues for The Wall Street Journal.