Major Tax Benefits of ESOPs

Employee Stock Ownership Plans (ESOPs) serve as an essential tool for building long-term company stability and enhancing employee satisfaction. Beyond these perks, ESOPs offer unique tax advantages that can significantly boost a company’s savings and benefits. 

In this article, we'll provide an overview of these tax benefits so you have a basic understanding of how to maximize your company’s savings potential by offering an ESOP. We encourage you to set up a consultation with a tax professional who specializes in ESOPs for more detailed guidance. 

Tax Treatment of ESOPs

If you’re wondering how an ESOP is taxed, the tax advantages that can be unlocked with ESOPs can be split into two groups: Tax advantages for C corporations and tax advantages for S corporations. Let’s take a look at each. 

ESOP Tax Benefits For C Corporations

As per Section 1042, C corporation companies with ESOPs can benefit in the following ways each tax year:

• Contributions for Loan Payments: Contributions used to pay ESOP loan interest are tax-deductible. Contributions used to repay ESOP loan principal can also be deducted from up to 25% of covered payroll.
• Additional Contributions: The combined limit for all employer contributions (including both principal payments and other contributions) is 25% of eligible payroll.
• Seller Tax Deferment: Sellers owning at least 30% of the company stock can defer taxation on their gains. They can reinvest the proceeds from the sale in other securities and continue to defer taxation. Certain eligibility requirements and limitations may apply. 
• Dividend Deduction: Cash used to pay company stock held by an ESOP is deductible, so long as the dividends are used to repay the ESOP loan or are passed through to employees. 

ESOP Tax Benefits For S Corporations

For S corporations, the benefits differ but are still advantageous:

• Tax Exemptions: Owners are not taxed twice on the ownership percentage held by the ESOP. Profits attributed to the ESOP are exempt from federal and sometimes state income tax. 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 wholly owned by its ESOP. Note, however, that the ESOP still must get a pro-rata share of any distributions the company makes to owners.
• Full Ownership Benefits: If an S corporation is 100% ESOP-owned, the ESOP shareholder is tax-exempt from federal income and most state income tax. However, Section 409(p) rules prevent benefits from being concentrated among highly compensated employees. 

Tax Advantages and Cash Flow Benefits of ESOPs

In leveraged ESOPs, companies can benefit from tax-deductible contributions used to repay ESOP loans. C corporations may also deduct qualifying dividends paid on ESOP-held shares. These tax advantages can improve cash flow, potentially providing additional capital for business investment that might not otherwise be available.

While ESOPs offer many tax advantages, it's important to note that all contribution limits are subject to certain limitations, as laid down by the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC).

Additional Tax Caveats

ESOPs are generally beneficial, but there are some limitations:

• ESOPs cannot be used in partnerships or in most professional corporations.
• Private companies must repurchase shares of departing employees (known as the “repurchase obligation”), which can become a significant expense.
• Setting up and maintaining an ESOP involves substantial costs, including initial setup ($125,000+), ongoing administration, annual valuations, and trustee services. 

ESOP Taxation Calculator

The National Center for Employee Ownership has put together a comprehensive toolkit for companies exploring ESOPs. This includes a tax advantage calculator, among many other helpful tools. Click here to start exploring the resources.

ESOP Trustee Services

As you consider your options for succession planning, Aegis Trust Company is ready to help you look at your ESOP options. Contact us today to explore how we can support your journey into employee ownership!