Major Tax Benefits
ESOPs have a number of significant tax benefits, the most important are:
- Contributions of stock are tax-deductible: A company can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP.
- Cash contributions are tax-deductible: A company can contribute cash on a discretionary basis year-to-year and take a tax deduction for it, whether the contribution is used to buy shares from current owners or to build up a cash reserve in the ESOP for future use.
- Contributions used to repay a loan the ESOP takes out to buy company shares are tax-deductible: The ESOP can borrow money to buy existing shares, new shares, or treasury shares. Regardless of the use, the contributions are deductible, meaning ESOP financing is done in pretax dollars.
- Sellers in a C corporation can get a capital gains tax deferral: In C corporations, once the ESOP owns 30% of all the shares in the company, the seller can elect under IRS section 1042 to reinvest the proceeds of the sale in other securities and defer any tax on the gain. Similar to like-kind exchanges involving real estate, the selling shareholder can replace his stock in a private company with diversified stock or bonds in publicly traded US corporations without triggering gain tax on the sale to the ESOP.
- In S corporations, the percentage of ownership held by the ESOP is not subject to income tax at the federal level (and usually the state level as well): That means, for instance, that there is no income tax on 30% of the profits of an S corporation with an ESOP holding 30% of the stock, and no income tax at all on the profits of an S corporation 100% wholly owned by its ESOP.
- Dividends are tax-deductible: Reasonable dividends used to repay an ESOP loan, passed through to employees, or reinvested by employees in company stock are tax-deductible.
- Employees pay no tax on the contributions to the ESOP, only the distribution of their accounts, and then at potentially favorable rates: The employees can roll over their ESOP distributions in an IRA or other retirement plan or pay current tax on the distribution, with any gains accumulated over time taxed as capital gains.
Note that all contribution limits are subject to payroll and other limitations, but ESOP Strategies LLC will help you navigate these waters smoothly.