An ESOP is an employee benefit plan which owns the stock of the company for the benefit of the employees. It is often seen as a great motivating tool for employees to work hard, be more productive, and share in the wealth of a growing company. For companies, it can become a method of lowering tax burdens. For owners, it provides a means to sell their interest often at a great tax advantage and on their own timeframe.
An ESOP is one of the only business transition tool that allows an owner to sell their interest in their company gradually over time or all at once (as in a traditional sale to a third party).
For an owner, it can be a great way of ensuring a smooth transition to the next generation of managers, whether that be the next generation of family members or a trusted management team. It also can provide significant tax savings to the owner and the company as well as being a unique employee motivator and value driver.
Contributions to ESOPS are tax deductible. There are limits as there are with most plans. If an ESOP is leveraged, the deductibility is even higher. With leverage, the ESOP or its corporate sponsor borrows money from a bank or other qualified lender. The company usually gives the lender a guarantee that it will make contributions so the trust can pay back the loan. A company which repays an ESOP loan gets to deduct principal as well as interest from taxes. Dividends paid on ESOP stock passed through to employees or used to repay the ESOP loan are also tax deductible if the sponsor is a C corporation.
An advantage to having an ESOP in an S-corporation (where profits are passed through to the shareholders via a K-1) is that the ownership percentage owned by the ESOP trust is tax free. The ESOP trust is a tax exempt entity; therefore, no tax is due on the ESOP’s share of the sponsor’s income. In a 100% ESOP owned s-corporation, there are no corporate taxes due.
Taxes are paid when ESOP participants receive a distribution from the retirement plan with the same tax advantages and rollover opportunities to the employee that are available on distributions from all other types of qualified retirement plans like 401(k)s.
Owners of closely held C corporations can sell their stock to the ESOP and defer federal income taxes on the gain from the stock sale. The ESOP must own at least 30% of the company’s stock immediately after the sale and the seller must reinvest the proceeds in securities of domestic operating companies within either three months before the sale or twelve months after the sale. There are some other restrictions. In a nutshell, the seller can cash out fully or partially tax free. Not until the securities he or she bought with the sale proceeds are sold are any federal taxes payable.
An attorney and an ESOP specialist should design the Plan with your guidance to avoid any legal or tax consequences. ESOP implementation and maintenance can be costly. A property-designed plan using qualified professionals can mitigate these costs.
At JBV, we are here to assist you.