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Tax Advantages of ESOPs: C and S

Introduction

In order to broaden the ownership of capital to provide employees with a stake in the ownership of their employing corporation and to provide a unique means of financing to corporations, Congress has granted a number of specific incentives meant to promote increased use of the ESOP concept. This is especially true for leveraged ESOPs, which through the use of borrowed funds provide a more accelerated transfer of stock to employees. These ESOP incentives provide numerous advantages to the sponsoring employer and can significantly improve corporate financial transactions.  The leadership of a corporation setting up an ESOP will need to understand the different tax advantages available to a C corporation compared to an S corporation and vice versa.

Deductibility of ESOP Contributions

As with all tax-qualified employee benefit plans, contributions to ESOPs are tax deductible to the sponsoring corporation up to certain limits. These contributions can be either in cash (which is then used by the ESOP to buy employer securities) or directly in the form of employer securities. Where employer securities are contributed directly, the employer may take a deduction for the full value of the stock contributed. By doing so, the employer actually increases its cash profits by the value of the taxes saved through the deduction.

The deductibility of contributions to an ESOP becomes even more attractive in the case of a leveraged ESOP. Under this arrangement, an ESOP takes out a cash loan from a bank or other lender, with the borrowed funds being paid to the sponsoring employer in exchange for employer securities. Since contributions to a tax-qualified employee benefit plan are tax deductible, the employer may thereafter deduct contributions to the ESOP which are used to repay not only the interest on the loan, but principal as well. This makes the ESOP an attractive form of debt financing for the employer from a cash flow perspective. Each year, the company can deduct contributions of amounts up to 25% of covered payroll, plus any dividends on ESOP stock (see "Deductibility of Dividends" below) if a C corporation which are used to repay the loan. Further, any contributed amounts used to repay the interest on the loan are deductible without any limit at all.  [S corporations should check with ESOP counsel before using the interest as deductible.

ESOP Rollover

An additional ESOP incentive allows a shareholder, or shareholders, of a closely held C corporation to sell stock in the company to the firm's ESOP and defer federal income taxes on the gain from the sale. In order to qualify for this "rollover," the ESOP must own at least 30% of the company's stock immediately after the sale, and the seller(s) must reinvest the proceeds from the sale in the securities of domestic operating corporations within fifteen months, either three months before, or twelve months after the sale. The seller, certain relatives of the seller, and 25% shareholders in the company are prohibited from receiving allocations of stock acquired by the ESOP trough a rollover. Generally, the ESOP may not sell the stock acquired through a rollover transaction for three years.

The ESOP rollover provides a substantial tax advantage that might otherwise be unavailable to current or retiring owners. Normally, a direct shareholder's options would be to sell shares back to the company, if such a transaction is feasible, or to sell out to another company, either for cash or for a block of shares in the other company. Selling to an ESOP, on the other hand, allows the seller to exchange interest in the company for a safely diversified portfolio of securities—or the stock of a single new company—without paying any taxes on the transaction. The seller's tax basis in the employer stock which were sold will be carried over to the replacement property. If the replacement property is held until death, however, a stepped-up basis for those securities is provided under current established tax laws.

In addition to the substantial tax advantages, selling to the ESOP preserves the company's independent identity. A sale to an ESOP also provides a significant financial benefit to valued employees and can assure the continuation of jobs. Moreover, selling to an ESOP allows the seller to sell all or just a part interest in the company, and to do this gradually or all at once.

To qualify for rollover treatment, the stock sold to the ESOP must be common or convertible preferred stock of a closely held domestic corporation and must have been owned by the seller for at least three years.

Note, the owner of S corporation stock that she/he sells to an ESOP is not eligible for the ESOP rollover tax benefit.  Finally, if a C corporation pays dividends in cash to ESOP participants, and the participant decides the dividends he reinvented to acquire more employer securities for his or her account, the C corporation may take a tax deduction for the value of the dividends.

Deductibility of Dividends

Employers are also permitted a tax deduction for cash dividends paid on stock which has been purchased with an ESOP securities acquisition loan, to the extent that the dividends are passed through to the employees. This provision allows companies to share current benefits of stock ownership with their employees to complement the long term benefits of capital ownership. The dividends are taxable as current ordinary income to employees. Note, this tax benefit is not available to an S corporation, and in full, an dividend of an S corporation paid in cash to ESOP participants is deemed to be an early withdrawal from the ESOP, and would solicit the ESOP participant/recipient to his/her regular income tax plus a 10% early withdrawal penalty tax.

A deduction is also available for dividends paid on ESOP leveraged stock to the extent that the dividends are used to reduce the principal or pay interest on an ESOP loan incurred to buy that stock. Dividends used in this manner are not counted towards the 25% contribution limit for leveraged ESOPs. Some ESOPs have purchased convertible preferred stock rather than common stock to assure a relatively reliable stream of dividend income to be used in servicing the loan.

The deduction is also available if the ESOP participant directs the dividend be reinvested for more company stock.

Note, as a pass through entity, an S corporation would not take a deduction for dividends used to pay ESOP debt but the S corporation may use the dividends as leveraged ESOP shares to pay ESOP debt.

Unique S Corporation Tax Advantages

Since 1998, S corporation, which as so-called “pass through” entities since there is no federal tax imposed as corporate taxable income; instead the S corporation’s taxable income is pro-rata share individual shareholders who report the taxable income of the S corporation on their individual returns.

When an ESOP trust, which is a tax exempt entity, is a shareholder of an S corporation, its pro-rata share of S corporation sponsor’s income is not currently taxes.  When ESOP participants receive a distribution from the S corporation, she/she pay an income tax on the value of the distribution.

Many S corporations that sponsor ESOPs have 100% of the S corporation stock held by the ESOP.  In this status, the S corporation’s taxable income is not currently taxed at the federal income tax.  [Most states corporate income tax laws mirror the federal tax regime.  Check with tax counsel to know the state law of the state where the S corporation is located and/or operates.]

S corporations with ESOPs holding less than 100% of the company stock have the advantage of having plenty of the cash in the ESOP to pay repurchase obligations, as the ESOP receives it pro-rata share of any cash distributions for the corporation to the shareholder.