For nearly 50 years, Employee Stock Ownership Plans (ESOPs) have been used to foster the growth and ownership of private companies by their employees. Studies show that ESOP-owned companies are generally more productive, have more engaged employees, and are substantially more likely to have additional retirement-oriented benefit plans than comparable non-ESOP companies. The advantages don’t stop there. Favorable tax rules exist that help promote and accelerate the growth of ESOP-owned companies.
ESOPs were created as part of the Employment Retirement Income Security Act (ERISA) passed by Congress in 1974. The purpose of an ESOP is to assist employees in acquiring a beneficial ownership in their employer without using their own capital. The employees only have a beneficial ownership interest in an ESOP, rather than actual ownership, because the ESOP is actually a trust (known as an ESOT) that is a qualified retirement plan investing primarily in the employer’s stock.
The tax advantages vary depending on the type of entity being purchased by the ESOT. If the company is a C Corporation, the owner(s) can sell their stock to the ESOP on a tax deferred basis, as long as the ESOT owns at least 30 percent of the company after the sale. The gain on the sale of their stock is deferred if the proceeds of the sale are invested in “qualified replacement property” within a specific timeframe. Qualified replacement property is defined as stocks and bonds of U.S. operating companies. The tax deferral can become permanent if the qualified replacement property is held until the seller’s death. The securities are inherited by the seller’s estate and the securities receive a stepped up basis, thereby deferring gain recognition from the initial sale permanently. We will discuss this topic in more detail below due to potential tax law changes.
After the stock is sold to the ESOP, the C Corporation can elect to be taxed as an S Corporation, which has unique tax advantages when owned by an ESOP. S Corporations pass income through to their shareholders. The income that is allocated to the ESOP, which is a tax exempt entity, is exempt from federal and most state income taxes. Removing the tax burden for ESOP-owned S corporations generally allows the business to focus more aggressively on allocating resources to growth and paying off debt.
In a typical ESOP transaction, the ESOP uses debt to finance the stock purchase. Since the ESOP has no collateral, the selling corporation will borrow funds and then loan them to the ESOP to purchase its stock. The corporation is allowed to deduct its principal and interest payments while paying down the debt.
It should be noted that this article was written prior to the passage of any proposed Biden tax reform. President Biden has proposed increasing the capital gains tax rate and removing the step-up in basis upon death, which would impact some of the tax advantages for owners who sell their stock to an ESOP. The tax deferral could still be valuable, but the opportunity to permanently defer the gain from taxation may be removed.
An ESOP offers unique tax advantages to business owners thinking about an exit strategy for their privately held company. If you are considering selling your business, you should carefully analyze an ESOP for its tax and non-tax advantages and in light of proposed tax reform.
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