Many companies eyeing the benefits of an ESOP are waiting to see how the new tax law changes will affect the tax benefits of employee ownership. However, it appears that the tax benefits associated with an ESOP will continue and even expand into the future. S corporations may soon get some of the same ESOP benefits as C corp owners, allowing some companies to operate free of federal income tax.
Employee Stock Ownership Plans (ESOPs) are qualified retirement plans that invest in employer securities. The ESOP operates as a tax-exempt employee stock ownership trust, or ESOT. An ESOP allows employee participants to acquire an ownership interest in the company as a benefit of working for the company.
An ESOP has tax savings benefits for employees, selling shareholders, and the company. These financial benefits are in addition to the benefits of increased productivity and reduced turnover that are generally associated with ESOPs.
Under Internal Revenue Code (IRC) section 1042, for some corporations, shareholders can defer capital gains tax on stock acquired by the ESOP. To qualify, the ESOP needs to own at the time of the sale (inclusive of shares previously owned and those acquired as part of the sale) 30% or more of the company stock and the owner needs to reinvest the proceeds in qualified replacement property (QRP) within 12 months from the closing date of the sale.
Another benefit to the company provides that when dividends are passed through a C corp ESOP to participants, those stock dividends are treated as tax-deductible. The company can also use those tax-deductible dividends to make principal or interest payments on ESOP loans.
An S corp ESOP Trust is tax-exempt from corporate level income taxes. Tax savings pass on to the employees and may result in increased value if company stock is allocated to their accounts. Normally, if an employee is given company stock, the employee would be taxed on those shares. However, under an ESOP, participating employees acquire an interest in the stock without having to pay tax on the stock when allocated to their accounts. The tax is deferred until the ESOP makes distributions to the participant.
Employees also maintain the tax benefits until retirement or until they leave the company. Generally, employees are not taxed on their ESOP interests until they take a distribution.
Companies considering ESOP ownership, partial ESOP ownership in 2018, or even existing ESOPs may want to compare the costs and benefits of electing to be treated as a C corp or S corp. The new lower C corp taxes may have some S corps reconsidering their entity choices.
There are a lot of factors to consider, before deciding the right ESOP-owned corporation tax status as an S or C corp, or whether it is worth converting. However, pending legislation may soon level some aspects of the playing field for ESOPs, regardless of whether they are C corps or S corps.
If you have any questions about the tax savings of an ESOP for the company, owners, or employees, the law firm of Butterfield Schechter LLP is here to help. We are San Diego County's largest law firm focusing its law practice on employee benefits law and ESOPs. Contact our office today with any questions on how we can help you and your business succeed.