ESOPs, like all investment vehicles, have certain tax considerations. We provide the guidance you need to understand these tax features and design your ESOP to best suit the needs of all parties involved. Here are some ways tax law can impact the various parties involved in an ESOP.
- Owner: A C corporation owner who sells stock to an ESOP that owns at least 30% of the company’s stock at the end of the transaction can defer tax on the gain from the sale by rolling the proceeds into a similar investment in U.S. operating company stocks and bonds (e.g., most publicly-traded stock on U.S. stock exchanges). This is known as a “1042 exchange.” Note that this option is not available to S corporation shareholders.
- Participants: No tax is due when stock is credited to a participant’s account because the ESOP is a qualified retirement plan under the Internal Revenue Code. The participant will pay capital gain tax and income tax on distributions, plus a 10% penalty if the distribution is before normal retirement age. These taxes may be deferred by rolling distributions into an IRA or another retirement plan.
- Corporations: Up to certain limits, corporations that offer ESOPs can deduct:
- The value of stock they contribute to the ESOP.
- Cash contributions the ESOP uses to buy stock.
- Cash contributions the ESOP uses to make principal payments on a loan used to buy stock.
Generally speaking, the corporation can deduct a portion of the contribution – up to 25% of payroll. This limit applies across all of the employer's defined contribution plans. In other words, if the employer has a 401(k) and an ESOP, the deduction for contributions to both plans cannot exceed 25% of payroll.
For C corporations, there is a separate 25% deduction limit for contributions to a leveraged ESOP that are used to pay down principal on the ESOP’s loan. An S corporation cannot take advantage of this separate 25% deduction limit. S corporations must also include in the deduction limit contributions that are used to pay interest on the ESOP’s loan in addition to principal payments.
Dividends paid on ESOP-owned shares are usually also deductible and are not subject to the 25% deduction limit.
- ESOP: The ESOP trust is a tax-exempt vehicle that pays no tax on its income. This means that the ESOP’s share of the corporation’s income is tax-free in an S corporation because the corporation's income is only taxed at the shareholder level and not at the company level like it is in a C corporation.
With the professional guidance from an ESOP expert at Employee Benefits Law Group, we can help you design an ESOP to maximize the tax benefits an ESOP can offer. Contact us to learn more.
Are you interested in learning more about how many shares an owner should sell to the ESOP? Read our fourth blog post in this series outlining this decision making process.