ESOP Tax Incentives for Business and Employees

ESOPs, or Employee Stock Ownership Plans, have many significant advantages for businesses and their employees. Among the advantages are a number of special tax benefits meant to incentivize employers to contribute to their ESOPs. Employees, too, have major tax benefits that they can maximize strategically upon receiving ESOP distributions. Abrams Valuation Group explores the ESOP tax advantages for employers and employees.

ESOP Tax Incentives for Businesses

Numerous tax incentives encourage companies to establish ESOPS, offering businesses an excellent range of tax benefits. With some strategic planning, an ESOP can act as both an employee retirement benefit and a crucial part of a company’s tax strategy. Due to the many ESOP tax rules and regulations surrounding these incentives, the company structure and ESOP type limit the amount of ESOP tax incentives a company can utilize. Let’s break down the details of ESOP tax incentives.

ESOP Tax Advantages for C-Corporations

1. The most prominent incentive is that the ESOP sponsor company can deduct cash or stock contributions to the ESOP from its taxes up to a limit of 25% of payroll. This directly reduces the company’s taxable income and slashes its tax bill.

2. Because stock contributions to the ESOP are tax-deductible, the company can issue more shares of stock to the ESOP to gain more cash for immediate use. This can be particularly helpful if the company has a cash flow lag. However, it is important to consider that issuing more company stock shares dilutes the existing stock’s value. Therefore, it is not an ideal fast cash solution.

3. According to IRC Sec. 404(k), the ESOP sponsor can deduct dividends paid on the company stock held by an ESOP if the dividends are immediately distributed to ESOP participants or their beneficiaries in cash. This generally holds true even if ESOP participants reinvest the dividends into the ESOP to acquire additional company stock. Dividend payments are generally excluded from the 25% limit but are subject to certain limitations.

4. The company can take a tax deduction for the annual contributions to the ESOP as a qualified retirement plan, up to 25% of payroll.

5. Contributions to repaying an ESOP loan, including interest, (i.e., a loan that the ESOP took out to buy company shares from the ESOP sponsor) are tax-deductible. This means the ESOP is essentially financed with 100% pretax dollars. However, the amount of tax-deductible interest repayments is capped at 30% of adjusted taxable income by IRC Sec. 163(j).

6. With the Section 1042 Rollover, an owner who sells their shares of company stock to the ESOP can defer personal capital gains tax, providing that the transaction meets the stringent requirements. This can be a huge tax advantage to an owner looking to exit the business, who may benefit more by selling to the ESOP rather than a third-party buyer. This ESOP tax benefit is only available to C corporations, but not to S Corporations.

ESOP Tax Advantages for S Corporations

The most notable ESOP tax advantage for an S Corporation is that the S Corp avoids corporate income tax entirely as a pass-through tax entity. This has significant tax benefits, and is the main reason many companies elect to remain S Corporations.

There are several tax disadvantages for S Corps when it comes to ESOPs. It’s important to be aware of the limited tax benefits so owners can make informed decisions.

S Corps cannot include ESOP loan interest repayments in their 25% tax deduction limit if the loan was made for the purpose of purchasing employer securities. However, if the ESOP loan was for another purpose, the interest may be tax deductible.

Furthermore, if the S Corp owner wants to sell to the ESOP without capital gains tax (utilizing the Section 1042 rollover), they must first convert the company to a C corporation before the transaction. Converting the S Corp to a C Corp means that the S Corp loses its ability to step up its basis of assets upon a future sale to a C Corp, losing a significant tax advantage.

While S Corps can certainly maximize the ESOP tax benefits available to them, they may be limited in comparison to how C corporations can benefit from ESOPs. The ultimate tax savings and strategy will depend on the specific company’s financial and business profile. As with any weighty financial decision, Abrams Valuation Group, Inc. encourages business owners to discuss the options thoroughly with a trusted ESOP advisor.

ESOP Tax Advantages for Employees

ESOPs have plenty of tax benefits for employees who participate in the program.

1. ESOPs give employees a way to save money towards their retirement tax-free while gaining ownership in the company. All contributions employees elect to make to their ESOP account (depending on the particular ESOP setup and rules) are tax-deductable.

2. Departing employees only have to pay tax on the capital gains from the ESOP distribution (the distribution is not subject to income tax). With the proper tax planning, the employee can also reduce or defer their capital gains tax bill.

ESOP Rules and Regulations

As a qualified tax-advantaged retirement plan, ESOPs are subject to a number of rules and regulations that influence establishing and maintaining an ESOP. Staying compliant with the all ESOP requirements is an administrative burden, but for many companies the ESOP tax benefits are worth investing the administrative time and expense.

As an employee benefit plan, ESOPs must be ERISA compliant (Employee Retirement Income Security Act of 1974) and comply with the strict regulations of the Internal Revenue Code and applicable federal and state laws.

ESOP plan managers have numerous duties to comply with ERISA guidelines. These include fiduciary duties to ensure they act in the ESOP participants’ best interests and avoid prohibited transactions that could create a conflict of interest for the ESOP plan trustee.

Stock Ownership Plan ESOP Valuation

Obtaining an independent ESOP Valuation is a crucial part of establishing and maintaining a compliant ESOP. The valuation determines the fair market value of the company’s stock at the outset of the plan. In a Leveraged ESOP, this helps the ESOP trustee negotiate the final price at which that they will buy the stock from the ESOP sponsor. In a non-leveraged, or contributory ESOP, the valuation determines the value of the company stock each time the company issues new shares to the employee trust. In both ESOP setups the valuation is a critical part of establishing the company’s tax-deduction as well as their tax obligation, which is all based on the value of the stock.

Throughout the lifetime of the ESOP, an appraiser will perform an annual valuation to determine the fair market value of the company stocks at that point in time. This is, once again, a crucial part of maintaining a fair and compliant ESOP. This valuation report keeps ESOP participants informed about the current value of their ESOP shares. This is important as it enables employees to make strategic decisions about when and how to leave the company. Furthermore, when an employee leaves the company, their ESOP distribution (and capital gains tax obligation) is calculated based on the most recent fair market value of the company stock, as determined by the valuation.

Employee Stock Ownership Plan Distribution Rules

ESOPs can structure distributions in different ways. Depending on the departing participant’s personal tax profile, these schedules may have different tax implications.

Generally, ESOP benefits are paid to departing employees in a single lump sum. Alternatively, the payment can be spread into substantially equal payments over five years or less. If the value of the vested employee’s ESOP distribution totals over $1.38 million (IRS limit for 2024), then the ESOP can extend the distribution schedule over more than 5 years. According to the 2024 IRS COLA adjustments, the ESOP can extend the distribution for an additional one year per $275,000 that the account exceeds $1.38 million, up to an additional 5 years.

Depending on the setup of the ESOP, there may be distributions made to plan participants while the employee is still employed. An ESOP participant needs to discuss the tax implications of all ESOP distributions with a qualified tax professional to maximize their ESOP tax advantages.

Non-Tax Advantages of an ESOP

Beyond tax advantages, ESOPs are attractive to both employers and employees for several non-tax reasons. ESOPs can give employees a sense of ownership, motivating them to perform better and contribute to the company’s success. This can lead to to increased employee productivity and job satisfaction. In addition, ESOPs give employees an extra retirement benefit on top of salary compensation for their work, motivating them to stay with their ESOP employer.

From the employer’s perspective, ESOPs are an excellent employee retirement benefit and a powerful tool in attracting, hiring, and retaining top talent in their company. This can contribute to a much higher ROI of investing in employee training and advancement, as engaged employees at ESOP firms are more likely to stay employed at the same company for longer. Furthermore, there is substantial evidence that highly engaged ESOP company workforces outperform non-ESOP competitors in sales growth by an average 2.3% per year.

Overall, ESOPs offer many advantages for companies and employees, including tax savings and other related benefits.

Conclusion

Establishing a company ESOP offers significant tax advantages for both employers and employees. The benefits of ESOPs reach far beyond tax savings, as there are numerous non-tax advantages as well. ESOPs can be a valuable tool for strategic succession planning, employee retention, and motivation. Although ESOPs come with many administrative responsibilities to ensure compliance with relevant rules and regulations, many companies have found the benefits far outweigh the costs.

Still unsure if an ESOP is right for your company? Book a free consultation with Abrams Valuation Group, Inc. ESOP experts. We’ll explore your company’s profile together to determine if an ESOP is the right choice for your company. Looking for an independent ESOP valuation to establish or maintain an ESOP? Join the many companies who have already benefitted from AVGI’s 30+ years of ESOP experience. Give us a call today.