ESOPs (Employee Stock Ownership Plans) can benefit you, your employees, and your company. In fact, Congress has enacted a series of remarkable tax incentives designed to encourage employers to adopt ESOPs. Of course, ESOPs are not for everyone. Some business owners are not particularly concerned with the liquidity of their wealth or contemplating retirement and may prefer to maintain sole ownership of their company. And some businesses may not be appropriate for ESOPs — such as companies that are unprofitable or that have only a short-term industry outlook. But the benefits of ESOPs are by no means limited to large companies. Most small and medium-sized businesses are well suited for ESOPs. Following are ten important tax incentives relating to ESOPs:
- The company’s contributions to an ESOP are tax-deductible (within applicable limits) and tax-free to ESOP participants until they receive their distribution.
- The income of an ESOP trust fund is exempt from federal and California income tax (except to the extent Unrelated Business Income Tax shall apply to the trust).
- Special IRA “rollover” provisions and special tax treatment of appreciated company stock with ESOPs can defer the tax on distributions from ESOPs to employee-beneficiaries or, in certain circumstances, permit gains from distributions in the form of company stock to be taxed as long-term capital gains.
- You may sell stock of your closely held subchapter C corporation to an ESOP on a tax-deferred (potentially income tax-free basis), if (a) the ESOP owns at least 30 percent of your company’s stock immediately after the sale, and (b) you reinvest the sales proceeds in securities of other domestic operating corporations.
- Purchase of a company can be leveraged through use of ESOP borrowed funds to purchase the target company’s stock.
- If your company uses an ESOP to obtain a loan, the company is entitled to income tax deductions for both loan interest and principal payments – instead of on interest payments only (as in an ordinary corporate loan).
- Interest rates on loans to ESOPs sometimes are less than rates for other commercial loans.
- Cash dividends on shares held by an ESOP of a C corporation are deductible if passed along to ESOP participants — or if used to pay off a loan used to finance the purchase of company stock.
- Premiums for key-person insurance owned by the ESOP are fully deductible.
- Cashless deductions are available through the contribution of the company’s own stock to the ESOP, freeing up dollars for other company needs.
About the author: Marc Schechter specializes in employee benefits, ERISA, and business matters, with special emphasis on ESOP transactions. Mr. Schechter is admitted to practice before the courts of California and New Jersey; the United States District Court for the Southern and Central Districts of California; the United States Tax Court; the Ninth Circuit of the United States Court of Appeals; and the United States Supreme Court. He is a member of the Employee Benefits-Taxation Section, State Bar of California; Taxation Section, San Diego County Bar Association; and a former member of the Legislative and Regulatory Advisory Committee, ESOP Association of America.