ESOP: Tax Advantages of an Employee Stock Ownership Plan

How ESOPs Differ From 401(k)s

An employee stock ownership plan (ESOP) offers a range of attractive benefits for a sponsor company and its owners and employees. Both provide retirement benefits. Employees contribute directly to their 401(k), and employers may also contribute. However, employing companies are the sole contributors to ESOPs.

Unlike a 401(k), which relies on outside stocks, bonds, and mutual funds, an ESOP invests in the employing company’s stock. Employees then become owners of their company, participating directly in its growth and success.  An ESOP incentivizes and retains employees.

Tax Advantages

Employee stock ownership plans offer compelling tax advantages, including

• Deductibility of employer contributions and dividends
• Tax deferral on the sale of a C corporation to an ESOP
• Tax-free ownership of S corporations
• Tax deferral for gains realized by employee participants

Tax Advantage #1 – Deductibility of Contributions and Dividends

The sponsoring company makes contributions of cash, stock, or other assets to its ESOP.  These contributions are tax-deductible for the sponsoring company, subject to certain limitations. A sponsoring employer may deduct up to 25% of the company’s covered payroll.  Tax-saving deductions enhance a company’s cash flow and provide opportunities for further growth through acquisition, employee retention, and capital investment.

In the case of a C corporation with a highly-leveraged ESOP, contributions made by a sponsoring employer to repay loans are not included in the 25% limit. Under this arrangement, an ESOP takes a cash loan from a lender. The borrowed funds are disbursed to the sponsoring company in exchange for company securities. The sponsoring company may thereafter deduct contributions to the ESOP used to pay principal and interest on the loan.

Sponsoring employers may deduct dividends on ESOP-held stocks. Like contributions made by a C corporation for loan repayments, dividends issued by C corporations to an ESOP are usually not included in the 25% limit.

Tax Advantage #2 – Tax Deferral on the Sale of a C Corporation to an ESOP

For owners selling their business, an ESOP provides benefits not available with traditional succession-planning techniques. An ESOP enables owners to remain involved in the business and facilitates a seamless transition for management. However, for owners looking to sell the majority of their business, tax savings from a sale to an ESOP can mean greater profits.

When selling at least 30% equity in a C corporation, sellers can defer paying taxes on the sale proceeds for a potentially indefinite period. Under Section 1042 of the Internal Revenue Code, a seller who, within 12 months of sale, uses all or a portion of their sale proceeds to purchase qualified replacement property does not pay taxes on those amounts. According to the IRS, qualified replacement property (QRP) is a security issued by a domestic corporation that did not, in the prior taxable year, have passive investment income.

Similar to a Section 1031 real property exchange, the purchase of qualified replacement property treats that portion of sale proceeds as an asset exchange as opposed to a recognition of taxable income. Provided a seller holds the qualified replacement property until death, they avoid taxation completely. The property transfers to the seller’s heirs on an intensified tax basis. By investing in a QRP, the seller avoids capital gains on the original sale of the stock.  Sellers can leverage qualified replacement property to extract liquidity without triggering a tax recognition event.

In certain circumstances, institutional lenders allow a seller to borrow up to 90% current market value of such collateral, and these borrowed funds can be used freely.

Tax Advantage #3 – Tax-Free Ownership (S Corporation)

An S Corporation can sponsor an ESOP,  creating a tax-efficient entity. In comparison to a C corporation, the traditional S Corporation avoids double taxation on corporate earnings as income passes through the corporation to the owners, where it is taxed at capital gain rates.

In the case of an ESOP-owned S Corporation, corporate earnings pass through to the ESOP and are not taxed at the shareholder level. The ESOP is a tax-exempt entity. Thus, a 100% ESOP-owned S Corporation results in an income tax-free vehicle. That creates increased cash flow, which can subsequently generate further shareholder value.

Tax Advantage #4 – Tax Deferral for Employees

Employees can also benefit from ESOP income tax deferral. Distributions allocated to participants’ accounts are tax-deferred while they are held in the plan. Employees can further defer tax liability by rolling income distributions into an alternate retirement vehicle, such as an IRA, which allows employees to prepare for retirement in a tax-efficient manner.

 Is an ESOP The Right Choice?

More and more companies are discovering the employee stock ownership plan (ESOP) as an attractive and powerful tax planning technique. With the help of experienced advisors, an ESOP could allow you and your business to take advantage of a robust number of benefits.

You might also like:

• The Benefits of an ESOP Transaction for the Seller and the Company
• Assembling the Right Transaction Team: Tips for Selling Your Company

[Editor’s Note: To learn more about this and related topics, you may want to attend the following on-demand webinars (which you can listen to at your leisure and each includes a comprehensive customer PowerPoint about the topic):

• ESOPs 101 
• An Ounce of Prevention: Policies, Procedures, and Proactivity
• The Intersection of Bankruptcy and…Tax Law

This is an updated version of an article originally published on May 3, 2019. It has been updated by Cathy Cagle]

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