Employee Stock Ownership Plans (ESOPs) allow business owners and their successors to achieve their business planning goals while minimizing the “tax bites” on the business transfers. In order to sponsor an ESOP, a company must be incorporated as an “S” or “C” corporation. Tax benefits of an ESOP will differ depending upon whether the business is a “C” or an “S” corporation.
The ESOP planning strategy provides:
- It allows business owners to control the transactions and sell on their terms. They are be able to sell all or a portion of their companies and negotiate terms with “friendly” buyers.
- The sellers are able to retain some key company-provided perquisites, including country club memberships, company cars and medical insurance.
- Owners are able to:
- Ensure financial security for themselves, their families and employees;
- Provide successors with clear succession plans containing determinable endpoints; and
- Transition gradually into retirement, moving from business operators to management mentors.
- The typical ESOP succession plan is substantially less expensive (generally 50% less) than a sale to a third party.
- Finally, the typical ESOP succession plan would minimize the tax bite by more than 50%.
ESOP Tax Benefits
- Company Contributions to the ESOP are a tax-deductible expense.
The buyout of the owner’s stock is financed through what is referred to as the ESOP Loan. Because company contributions to the ESOP are used to pay off the ESOP Loan, the net result is that the company gets a tax deduction for both the principal and the interest on the loan.
- Taxes on reinvested proceeds are deferred indefinitely.
If the selling shareholder reinvests his or her ESOP sales proceeds in accordance with the like-kind exchange provisions in Internal Revenue Code section 1042, taxation on the sales proceeds can be deferred indefinitely.
- Companies can get tax deductions for dividends paid on ESOP shares if certain conditions are met.
The tax benefits of this ESOP structure are best appreciated by comparing an ESOP to other succession planning strategies such as corporate stock redemption or leveraged management buyout. Using an ESOP as opposed to one of these traditional succession-planning strategies reduces the tax bite by almost 50%.
“S” Corporations that sponsor ESOPs receive even greater tax benefits than those available to “C” corporations. Although the tax-deferred sales provisions of IRS section 1042 are not available to owners of “S” corporation stock, other benefits of the ESOP more than make up the difference.
One of the unique features of “S” corporations is that they DO NOT pay corporate income taxes. Instead, taxable income is “passed through” to their owners. Since an ESOP is a tax-exempt entity under section 401 of the Internal Revenue Code, income that “passes” through” the “S” corporation to its ESOP is not subject to taxation.