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The Tax Benefits of an ESOP

Feb 27, 2024

We’ve previously discussed how an employee stock ownership plan (“ESOP”) functions and the different structures that may be used. These plans continue to grow in popularity in large part due to their flexible tax benefits for both participants and companies. For companies, some benefits include the ability to deduct certain contributions and dividends from taxable income, succession planning for founders, and improved employee morale and retention. For employees, these benefits include the ability to defer income and taxes while gaining ownership in their employer.

Company Benefits

The sponsoring company will receive different benefits from implementing an ESOP depending on how the company is structured. Only C corporations and S corporations can take advantage of ESOPs – partnerships and sole proprietors are not eligible. As the ESOP owns the company stock, it is the beneficial owner of the company, whether the company is structured as a C corporation or an S corporation.

C Corporation Benefits

IRC Sec. 404(k) Dividends

Under IRC Sec. 404(k), C corporation ESOP sponsors may take a deduction for dividends that are paid with respect to the stock of such C corporation, provided the dividends are immediately distributed under the terms of the plan and certain distribution rules are met. Thus, C corporation ESOP sponsors can deduct dividends paid on the company stock that is held by an ESOP, in the event the dividends are distributed in cash to ESOP participants or their beneficiaries. If a sponsor decides to allow ESOP participants to make an election to reinvest the IRC Sec. 404(k) dividends back into the ESOP to acquire additional company stock, the dividend deduction may also be available. 

C Corporation Contributions and Dividends 

In terms of a C corporation owned by an ESOP, a company may deduct contributions (e.g., company stock or cash) up to 25% of covered payroll. Any contributions that are used to pay interest on an ESOP loan are excluded from the 25% limit, unlike an ESOP owned by an S corporation. However, interest expenses can be subject to limitations under IRC Sec.163(j), which limits interest expenses to 30% of adjusted taxable income (“ATI”). In addition, a C corporation may deduct dividends distributed to an ESOP plan outside of the 25% contribution limits, subject to certain limitations.

Leveraged ESOPs may offer the most appealing method to deduct ESOP contributions. For example, an ESOP sponsor or third-party lender can extend credit to the ESOP, which  will use the proceeds to obtain company stock from the selling shareholder or ESOP sponsor. Afterwards, the sponsor will contribute annually to the ESOP and the contributions will be used to repay the ESOP loan.

A C corporation ESOP sponsor may deduct:

  • Contributions used to repay the ESOP loan principal, up to 25% of the covered payroll amount;
  • The nonelective contribution, up to an additional 25% of covered payroll; and
  • 100% of the contributions that are used to repay the ESOP loan interest amount subject to the potential limitation by IRC Sec. 163(j) as noted above.

The additional deduction granted to C corporations in this instance is not available to S corporations.

IRC Sec. 1042 Transactions

A shareholder who sells shares of a C corporation to an ESOP may defer all capital gains taxes subject to certain requirements being met under IRC Sec. 1042. The company stock sold to the ESOP must have been owned by the shareholder for at least three years and it must be either common or convertible preferred stock (e.g., preferred shares that include an option for the holder to convert the shares into a fixed number of common shares after a preset date) issued by a C corporation. Additionally, the shareholders must reinvest the sale proceeds in qualified replacement property (“QRP”) within a certain period, and the ESOP must own at least 30% of each class of the outstanding company stock after the sale.

In an IRC Sec. 1042 transaction, the shareholder’s tax basis in the C corporation stock sold to the ESOP is carried over to the QRP, provided the ESOP owns 30% or more of the corporation’s stock after the sale. This transaction creates tax deferral on the realized capital gains until the date the QRP is sold. By completing this type of transaction, C corporation shareholders selling to an ESOP can defer capital gains taxes associated with such sale. This incentive is not available for S corporation shareholders.

S Corporation Benefits

An ESOP-owned S corporation can be created by the ESOP’s purchase of the selling shareholders’ company stock. One big advantage for an ESOP-owned S corporation is that it is not subject to federal income tax. If the S corporation distributes cash to the ESOP, no tax is paid on the distributed cash until the ESOP makes a distribution to the plan’s participants either at retirement, death, disability, or some other type of termination of employment. The fact that an ESOP-owned S corporation is not subject to tax makes it easier for the company to maintain the debt on its balance sheet.

Benefits for Employees

ESOPs provide both monetary and nonmonetary benefits to employees. For example, ESOPs allow employees the opportunity to participate in the economic ownership of a company while gaining a retirement benefit without having to make their own contributions to the ESOP. In addition, the value of equity in the company may appreciate over time and the taxes on the benefit are not paid until a distribution (e.g., retirement) occurs. As far as nonmonetary benefits, ESOPs allow employees to feel a greater stake in the company’s success, and thus the potential for increased productivity and happiness on the job.

ESOPs can offer the best of both worlds for companies and employees. Employees can increase their equity in a company while deferring taxes; while employers are able to deduct certain expenses and, in some cases, avoid income tax. Taxpayers who are considering implementing an ESOP should consult with a trusted tax advisor to determine their best options.

This is the second of a multi-part series on employee stock ownership plans. Read more:

ESOPs: How They Function and How They Are Structured

How ESOPs Can Help Cannabis Operators

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