An employee stock ownership plan, commonly referred to as an ESOP, offers a range of benefits for sponsor companies, in addition to its owners and employees. As a qualified employee benefit plan, an ESOP is designed to provide retirement benefits to employees, and is similar to that of a 401(k) plan. However, unlike a 401(k) plan where contributions are used to invest in a variety of outside stocks, bonds, and mutual funds, an ESOP invests in the stock of its employer. As a result, employees become owners of their company, participating directly in its growth and success.
In addition to being a qualified retirement plan and a useful tool to incentivize and retain employees, an ESOP offers many compelling tax advantages. Primary tax advantages of an ESOP include:
Deductibility of employer contributions and dividends,
Pursuant to plan requirements, a sponsoring employer is required to make contributions of cash, stock or other assets to the ESOP. While these contributions are tax-deductible to the sponsoring employer, they remain subject to certain enumerated limitations. Currently, the maximum contribution a sponsoring employer is permitted to deduct is 25% of the aggregate compensation of the plan participants. Tax-saving deductions enhance a company’s cash flow and provide opportunity for further growth through acquisition, employee retention, capital investment or otherwise.
In the case of a C-corporation with a highly leveraged ESOP, this tax benefit becomes amplified as contributions made by a sponsoring employer for purposes of loan repayment are not included in the 25% limit. Under this arrangement, an ESOP takes out a cash loan from a bank or other lender, with the borrowed funds being paid to the sponsoring employer in exchange for employer securities. The sponsoring employer may thereafter deduct contributions to the ESOP which are then used to repay not only the interest on the loan but principal as well.
Sponsoring employers are also permitted to deduct dividends paid on stock held by an ESOP. Similar to contributions made by a C-corporation for loan repayments, dividends issued by C-corporations to an ESOP are not included in the 25% limit provided they are reasonable in nature.
For owners interested in selling their business, an ESOP can provide a number of benefits over traditional succession-planning techniques. Tax benefits aside, an ESOP enables owners to remain involved in the business if desired, and facilitates a seamless transition for management upon a change of ownership. However, for owners looking to sell a majority of their business, the resulting tax savings from a sale to an ESOP can mean more cash at the end of the day.
In the case of a sale of at least 30% of the equity in a C-corporation, sellers can defer paying taxes on their sale proceeds for a potentially indefinite period of time. Under section 1042 of the Internal Revenue Code, a seller who uses all or a portion of their sale proceeds to purchase qualified replacement property (floating rate notes or stock or bonds of domestic operating companies) within twelve (12) months from the date of the sale does not pay taxes on such amounts.
Similar to a section 1031 real property exchange, the purchase of qualified replacement property effectively 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, taxation is avoided completely, as the property will be transferred to the seller’s heirs with an intensified tax basis. Thus, by investing in a QRP the seller can avoid all capital gains on the original sale of the stock. Further, sellers can leverage their qualified replacement property to extract liquidity without triggering a tax recognition event.
In certain circumstances, institutional lenders will allow a seller to borrow up to 90% of the current market value of such collateral, and these borrowed funds can be used freely.
An S-Corporation can also sponsor an ESOP, effectively creating a highly 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 then taxed at capital gain rates.
In the case of an S-Corporation with an ESOP owner, corporate earnings are passed through to the ESOP and will not be taxed at the shareholder level as the ESOP is a tax-exempt entity. Thus, an S-Corporation that is 100% ESOP-owned, results in a federal (and typically state,) income tax-free vehicle. The elimination of corporate income tax creates increased cash flow, which can subsequently be used to generate further shareholder value.
While ESOPs provide significant tax benefits for companies and non-ESOP shareholders, employees can also benefit from income tax deferral. Distributions allocated to participant’s accounts are deferred for so long as 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 for employees to prepare for retirement in a tax-efficient manner.
More and more companies are discovering 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 the benefits discussed in this article.
[Editor’s Note: While this article focuses on the advantages of an ESOP, there are certainly disadvantages, and the structure certainly is not a good fit for every situation. First, an ESOP is a qualified plan, governed by ERISA. As a practical matter, this adds a layer of expense and complexity that is simply not present in other companies. Second, the buyer will not be a strategic buyer and therefore the seller is less likely to receive as large of a purchase price as otherwise may have been possible. Third, sellers often have to finance part of the purchase price since employees typically do not have the cash necessary to contribute to the sale price. For more on this subject, please see our article, “Another Look at Tax Advantages of Employee Stock Ownership Plans Following Trump Tax Reform,” or check out our webinar: “ESOPs-101.”
If you want to read more about how to sell or otherwise exit a business, be sure to read “Business Transition and Exit Planning: Welcome to the Jungle!” It will lead you step-by-step through what you need to know.]
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