How Are ESOPs Taxed?June 26, 2017
As the adage goes, there are only three absolutes in life: birth, death, and taxes. Accordingly, few entities are spared the onus of taxation, and ESOPs are not among them.
For business owners considering the implementation of an ESOP, understanding the ins and outs of taxation is an important factor. Business tax in the U.S. is exceedingly complex, but a review of the main points can highlight the tax advantages that go into establishing an ESOP for your business.
Selling to an ESOP
The tax consequences of selling to an ESOP vary somewhat depending on the Sponsoring Company’s legal structure, whether it’s a C-Corporation or an S-Corporation. While many of the details and nuances are beyond this posting, let’s cover some of the more important aspects.
C-Corporations – When selling to an outside third party, most buyers want to buy the Company’s assets not the selling owner’s stock certificate. For C-Corporations this is a huge problem. The selling shareholder can actually experience double taxation. This problem is solved when selling to an ESOP in that all sales are treated as stock certificate sales subject to favorable long-term capital gain rates. But it gets better. If the selling shareholder sales at least 30% of the total ownership of the Company, he can actually elect to defer paying taxes on the gain altogether. He does so by taking the proceeds from the sale and reinvesting them into other publicly traded securities.
S-Corporations – Double taxation can be a problem for S-Corporation sales, depending on how long it has been since the Company made the election to be taxed as an S-Corporation. However, as stated above, since all sales to ESOPs are treated as sales of stock certificates they still benefit from favorable long-term capital gain rates.
ESOP Tax Advantages of ESOP-Owned Companies
C-Corporations owned by ESOPs still pay corporate income taxes, but because the annual contributions to the ESOP are tax deductible, the C-Corporation can experience a significant reduction in its annual tax bill.
When an S-Corp is owned by an ESOP, company profits are not taxed up the percentage of ownership held by an ESOP. So, if 85% of ownership is sold to an ESOP, 85% of the company’s profits will not be subject to income tax. This effectively provides an incentive for owners to sell most or all of their shares of stock to the ESOP plan in order to maximize savings.
ESOP Tax Advantages to Employees
As a tax-deferred benefit plan, participants can put off tax payments until withdrawal.
When an ESOP allocates shares into an employee's account, the action of receiving these shares is not taxable, much like contributions into a traditional 401(k). As long as these benefits stay within an ESOP account and are not withdrawn, no tax applies.
When an employee draws on their holdings within an ESOP, however, all distributions are subject to tax. The timing of this matters; whether a withdrawal occurs before age 59½ or after impacts the extent of taxation. If an employee under this age leaves the company and accesses his account, all relevant fees apply for use of tax-deferred retirement savings before the age cut-off. In order to postpone this particular form of taxable distribution, employees who leave the company and receive cash in exchange for their ESOP shares can reinvest this amount back into a traditional or Roth IRA. For those who use funds provided by an ESOP after the cut-off, this is taxed as any other retirement account distribution.
Participants who are at least age 55 and who have completed at least 10 years of participation in the ESOP, may elect to have some of their ESOP account diversified into other securities so that their retirement funds are not subject to the risk of a single investment.
Overall, ESOPs offer quite a compelling tax strategy for businesses looking to offset taxable income and help employees to save for the future. If your company is seeking an appropriate reprieve from the curse of corporate taxation, an ESOP may be the perfect way to save.
Written by Herbert Kalman