In the universe of exit strategies for owners of privately held companies there are, basically, five approaches – family transfers, mergers and acquisitions, third-party sales, sales to employees, and the Employee Stock Ownership Plan (ESOP). Alone among them, Congress deliberately designed the ESOP to provide tax advantages to the seller and company, and retirement benefits for employees.
ESOP’s tax advantages and benefits include:
- Tax deferral in connection with the sale of a C corporation to an ESOP;
- Deductibility of employer contributions and dividends;
- Tax-free ownership in the case of an ESOP owned S corporation; and
- Tax deferral for gains realized by employee participants.
The multiple tax-related advantages serve as a significant incentive to form an ESOP. In addition to the factors listed below, business owners should seek sound professional advice to learn more about the tax advantages of selling to an ESOP. seeking to learn more about the ESOP process, that may eventually bring about the tax advantages discussed below, should review other articles before reading the points outlined below.
ESOP Tax Advantage for Sellers: Deferred Taxes from C Corporation Sale Proceeds
A compelling tax advantage for owners interested in selling at least 30% of the equity in a C corporation is the ability to defer taxes due on their sale proceeds for a potentially indefinite period of time. Under Internal Revenue Code section 1042, sale proceeds used to purchase qualified replacement property (floating rate notes or stock or bonds of domestic operating companies) within twelve months from the date of the sale do not trigger tax consequences.
The purchase of qualified replacement property effectively treats the portion of invested sale proceeds as an asset exchange, as opposed to a recognition of taxable income. If the seller were to hold the qualified replacement property until death, taxes would be avoided when the heirs inherit the property and the tax basis is adjusted. That means that by investing in qualified replacement property, the seller can avoid capital gains on the sale of the stock. An added advantage to this strategy is it allows sellers to potentially leverage up to 90% of their qualified replacement property to receive immediate liquidity, without triggering a tax recognition event.
ESOP’s Tax Advantage for C Corporations: Deductibility of Contributions and Dividends
Another tax advantage of an ESOP can be recognized through tax deductible contributions and dividends by the sponsoring company. Tax-saving deductions benefit a company’s cash flow, thereby providing opportunity for further growth through acquisition, employee retention, capital investment or otherwise. In the case of an ESOP, the sponsoring company is required to make contributions of cash or stock to the plan, as specified in its plan document. However, the deductibility of ESOP contributions and dividends are limited to 25% of the aggregate compensation of the plan participants.
In the case of a highly leveraged C corporation, this tax benefit is especially significant as contributions made by a sponsoring company for purposes of loan repayment are not included in the 25% limit. In this scenario, an ESOP takes out a cash loan from a bank or other lender that is subsequently paid to the sponsoring employer in exchange for employer securities. The sponsoring company may then deduct contributions to the ESOP, which are then used to repay not only the interest on the loan but principal as well.
Dividends are also permitted to be deducted when paid on stock held by an ESOP. Similar to the deductibility of contributions made by a C corporation, dividends issued by C corporations to an ESOP are not confined to the 25% limit previously discussed.
ESOP’s Tax Advantage for S Corporations: Tax-Free Ownership
C corporations are not the only entities eligible to sponsor an ESOP. An S corporation can also sponsor an ESOP, which can create significant tax savings at the company level. In comparison to a C corporation, the traditional S corporation avoids double taxation on corporate earnings as income passes through the corporation to the owners to then be taxed at capital gain rates.
In the case of an S corporation wholly owned by an ESOP, corporate earnings are passed through to the ESOP and will not be taxed at the shareholder level as the ESOP is a tax-exempt entity. The elimination of corporate income tax creates increased cash flow, which can subsequently be used to generate further shareholder value.
ESOPs Tax Benefit for Employees: Tax Deferred Retirement Savings
While ESOPs provide significant tax benefits for companies and non-ESOP shareholders, employees can also benefit from income tax deferral. Distributions allocated to participants’ accounts are deferred as long as they are held in the plan. Employees can further defer tax liability by rolling income distributions into an alternate retirement vehicle such as an IRA, which allows employees to prepare for retirement in a tax-efficient manner. In many ways, but subject to certain limitations and conditions specified in every company’s plan document, the value held within the employee’s ESOP account functions much like any other traditional investment retirement account.
The Right Result
Powerful tax planning techniques and strategies related to an ESOP can greatly benefit sellers, sponsoring companies, and employees. Acuity Advisors can help you determine if an ESOP is right for you and for your company. While there are many possible outcomes to a transaction, there is generally one right result. Acuity Advisors can help you achieve it.