An ESOP is a type of employee benefit plan, similar in many ways to other tax-qualified retirement plans such as profit-sharing plans and governed by the same law – the Employee Retirement Income Security Act (ERISA). ESOPs are funded by the employer, not employees. Stock is held in trust for employees who meet minimum service requirements and allocated based on relative pay or a more equal formula over time, then distributed after the employee leaves the company, when it is generally repurchased by the ESOP or company. ESOPs cannot be used to share ownership with only select employees, nor can allocations be made on a discretionary basis.
Companies create ESOPs for a variety of purposes. Most commonly, they are used to:
- Provide a market for the shares of departing owners of closely-held companies,
- Motivate and reward employees with an additional employee benefit, or
- Take advantage of incentives to borrow money at a lower after-tax cost.
Owners of privately-held companies can use an ESOP to create a ready market for their shares. The company can either make tax-deductible cash contributions to the ESOP to buy out owners’ shares or it can have the ESOP borrow money to buy the shares. If the ESOP borrows cash, the company can make tax-deductible contributions to the ESOP to repay the loan, making both principal and interest deductible.
ESOPs have a number of significant tax benefits. A company can contribute cash, newly issued or treasury stock, and take a deduction. The annual top deduction is limited to 25 percent of covered payroll, aggregated with other defined contribution plans. Stock is valued at an appraised fair market value for the deduction. Note that stock contributions dilute existing owners of the company.
With C corporation stock, once the ESOP owns 30 percent of all the shares in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain. Dividends paid by C corporations used to repay an ESOP loan, passed through to employees, or reinvested by employees in company stock are tax deductible.
For S corporations, the income proportional to the percentage of ownership held by the ESOP is not subject to income tax at the federal level (nor generally at the state level either).
Although ESOPs have significant tax benefits, they are not for everyone. The company must generate enough cash to buy the shares, conduct its normal business operations, and make necessary reinvestments. Because there are limits on how much can go into an ESOP each year, payroll must be adequate to cover the purchase. If the company is borrowing to buy the shares, its existing debt must not prevent it from taking out an adequate loan. Sellers must be willing to sell their shares at fair market value, even if the ESOP pays less than a strategic buyer would.
Contact us at 215.441.4600 if you have questions or would like to discuss how this topic may impact your business.