ESOP

The Tax Benefits of Employee Stock Ownership Plans

As of 2019, the National Center for Employee Ownership (NCEO) estimates there are roughly 6,600 employee stock ownership plans (ESOPs) covering more than 14 million participants. About two-thirds of these ESOPs are used to provide a market for the shares of a departing owner of a profitable, closely held company. Most of the remainder are used either as a supplemental employee benefit plan or as a means to borrow money in a tax-favored manner. This can also be a great strategy for employers to reward employees for years of dedication and hard work.

So What Is An ESOP?

An employee stock ownership plan allows employees to become beneficial owners of the stock in their company. An ESOP must be designed to invest primarily in qualifying employer securities which allows employees to purchase stock at a discount from fair market value without any taxes owed on the discount at the time of purchase. Employees who participate in ESOPs can purchase stock directly, be given it as a bonus, receive stock options, or obtain stock through a profit sharing plan.

The Tax Benefits of an ESOP

The tax advantages associated with ESOPs can be significant for the selling shareholders and for the company. Cash contributions and contributions of stock are tax-deductible. This provides most companies experiencing a current cash flow the advantage to build up a cash reserve in the ESOP for future use. Contributions that are used to repay the loans the ESOP takes out to purchase company shares are also tax-deductible.

An S-Corporation allows owners to avoid double taxation on corporate earnings and their percentage of ownership held by the ESOP. This has provided a blanket exemption for S-Corp to not have to pay federal and sometimes state income tax on the percentage of their profits attributable to the ESOP.

A C Corporation has an additional tax benefit of allowing sellers who own at least 30% of the stock to defer taxation on the gain. ESOP sellers can reinvest the proceeds from the sale of other securities and defer any tax on the gain received.

Dividends that are used to repay an ESOP loan, passed through to employees, or reinvested by the employees in company stock are also tax-deductible.

Lastly, employees do not pay tax at the time of contributions into the ESOP. They are taxed at the time of distributions, and the rates they are taxed on is favorable to the participant. The ESOP distributions can be rolled into an IRA or other retirement plans accumulating gains over time taxed as capital gains later.

Conclusion

The benefits of an ESOP can be significant for selling shareholders, the management team, and the employees. However, the federal regulations governing ESOPs are complex and the cost of establishing and maintaining a plan may be greater than other types of retirement plans. As such, it is critical to consult with advisors who are knowledgeable about the legal, accounting, and administrative issues unique to ESOPs.

By Madeline Liu, Harris CPAs

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