Tax Advantages of an ESOP Transaction - Employee Benefits Law Group

You can defer your capital gains tax on the sale and then become a 100% employee-owned, income tax-free corporation. Here are the three principles you need to know:

The entire purchase price is deductible including the principal on the financing. It is the only tax-deductible debt in the Internal Revenue Code.
Sellers can elect to defer their capital gains tax on the sale of C corporation stock by making an IRC section 1042 election and reinvesting their proceeds into stocks and bonds of domestic corporations.
S corporation distributions, that you otherwise would have used to pay shareholder income taxes, will be paid to the ESOP because the ESOP is a shareholder and the ESOP can use the cash to pay off the ESOP financing. This is a direct tax subsidy.

How Will It Work for You?

You can test out assumptions for your situation using our calculator. The calculator shows you what the cost of your transaction might be and the associated tax benefits.

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Your Information & Inputs

Company Fair Market Value*

Estimate the value of 100% of the company. This is not your gross revenue, or net sales. Try 4-6 times your company's EBITDA (earnings before interest, taxes depreciation and amortization). If your EBITDA is below $1.5M, you will likely be too small for a leveraged or financed ESOP buyout. A non-leveraged ESOP strategy might work, however.

Corporation's Projected Income*

Estimate the company's annual "normalized" taxable income going forward. For this example, normalized means adding back or reducing for extraordinary and single year items of income, loss or deduction, and adding back any extraordinary compensation. Compensation expense reduces both taxable income and EBITDA and reduces value of the stock.

Percentage to Sell*

Enter the percentage of the company to be sold to an ESOP. This is generally anywhere from 30% up to 100%. Very rarely are sales below 30% as this is the minimum sale percentage required to elect the tax deferred rollover under IRC section 1042.

Please enter a number from 0 to 100.

Stock Basis*

What did you pay for your stock initially if it is a C corporation? Often it is nominal, dollars per share. If you don't know, enter zero. If you are an S Corporation your basis will be higher. If you don't know, your accumulated adjustments account (AAA) on your K-1 can serve as a proxy for this comparison.

W-2 Total Family Compensation*

Estimate the percentage of total annual W-2 payroll paid to the selling shareholder(s) and their family members. For example, if total payroll is $3,000,000 and the owner and their spouse each have W-2 earnings of $300,000, then the Family compensation is 20% of total payroll.

Please enter a number from 0 to 100.

Individual Tax Rate*

Based on your tax return what is the total tax rate you are paying on federal and any state income taxes combined.

Please enter a number from 0 to 100.

Individual Capital Gains Rate*

We assume a combined federal and California state individual capital gains tax rate of 33%. Change this for your situation.

Please enter a number from 0 to 100.

Interest on Bank or Seller Financing*

You can borrow from the bank or the seller or a combination in order to to buy the stock. Bank financing should be lower than seller financing. Perhaps start with your line of credit interest rate; or that plus 5% for seller financing.

Please enter a number from 0 to 100.

Rate of S Corporation Distributions*

How much cash is distributed by your S corporation to the shareholders each year? This should be entered as a % of K-1 income. Some distribute much more, sometimes up to 80% because the shareholders want more of the profit each year. This can have a dramatic effect on the comparison. If you are a C corporation, don't change the default input of 0. The calculator will compare your C corporation to a typical S corporation transaction.

Please enter a number from 0 to 100.

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Company Name

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Projected Normalized Taxable Income*

Estimate company's "normalized" taxable income going forward. If you are currently reducing taxable income to close to zero with tax deductions, what would it be if a buyer wasn’t driving the taxable income down? If you don’t have any taxable income, then you wont get tax benefits from an ESOPs deductions and incentives

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W-2 Payroll

How much is the company's total payroll for all full time employees working over 1,000 hours per year?

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Loan Length in Years

Over how many years do you want to be paid? - This is the length of the ESOP loan

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Corporate Tax Rate

If you are a C corporation, what rate of tax is the company paying? We assume that the company is paying taxes and will get the advantage of the ESOP incentives. If you are using a tax-driven strategy to reduce the tax burden to zero, perhaps with salaries and bonuses, what would be the tax rate if the company was paying taxes without these strategies. We have started with a combined federal and state tax rate of 33%.

Please enter a number from 0 to 100.

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Projected Revenue

Estimate the company's projected normalized gross revenue going forward.

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Projected EBITDA

Estimate the company's "normalized" EBITDA going forward.

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Seller Rate

Seller financing assumes a higher rate than the bank rate. If the seller will take a note, enter the proposed rate here (for example, 4% above the bank rate).

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Bank Financed

What percentage will be bank financed? (The rest is seller-financed.)

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Eligible Payroll

We assume 25% for W-2 eligible payroll.

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Transaction Values

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Purchase price of % to be sold at estimated company value.

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Seller's gain on the sale (purchase price less basis). This amount is not subject to federal income tax if you elect Code section 1042 rollover treatment - see below.

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Potential capital gains tax on sale.

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% Bank Financed

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% Seller Financed

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Total principal and interest cash cost to the company if bank-financed.

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Total principal and interest cash cost to the company if seller-financed.

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Total cost of financing

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ESOPs annual share of "Supplemental Distributions" above tax rate

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Note that annual loan payments should be less than this amount - 25% of total eligible employee W-2 payroll. (If not, then ESOP structuring should get around this if possible. To be conservative, lengthen the loan term.)

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Annual payment on bank financing. Can the company afford this? If not, lengthen the loan period in the inputs section above.

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Annual payment on seller financing. Can the company afford this? If not, lengthen the loan period in the inputs section above.

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ESOPs annual share of cash distributions

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Bank to Company Loan Amortization

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Loan Amount

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First Payment Date

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Payment

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Seller Note Loan Amortization

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Loan Amount

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Payment

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Potential Results of an S Corporation ESOP Transaction

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Tax savings from deducting principal on the loans by funding via the ESOP.

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ESOP's share of S Corporation's distributions during the loan period. This is "free cash" the ESOP can use to make loan payments.

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Total company tax "subsidy" from funding transaction with an ESOP.

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Net cash cost to company of financing transaction after ESOP tax "subsidy." (Assumes bank financing; seller-financing will be higher by amount of additional interest cost.)

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Compared to total cash cost to the company without an ESOP - using non deductible dollars, and no S corporation distributions.

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After-tax proceeds to seller without a 1042 rollover.

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After-tax interest paid on seller note (if seller-financed).

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If the company is an S corporation, seller could continue receiving S distributions in excess of their taxes paid in the 5 years after the sale. If the company revokes its S election to do a 1042 rollover transaction, seller won't receive these distributons during the 5-year wait to re-elect S corpation treatment.

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Stock account of family members participating in the ESOP (not available with 1042 election)**

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Total value to seller and family.

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Potential Results of a C corporation ESOP transaction

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Company's tax savings from deducting principal on the loan by funding via the ESOP.

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Net cash cost to company of financing transaction after ESOP tax "subsidy." (Assumes bank financing; seller-financing will be higher by amount of additional interest cost.)

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Compared to total cash cost to the company without an ESOP - using non deductible dollars, and no S corporation distributions.

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Tax-deferred proceeds to seller with a 1042 rollover (only available if company revokes S election or is already a C corporation).

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After-tax interest paid on seller note (if seller-financed).

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Value to family members participating in the ESOP (not available with 1042 election).

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Total value to seller and family.

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Comparison of Tax Benefits and Costs, C corporation

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Total principal and interest cash cost to the company*

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Tax savings from deducting principal on the loan by funding via the ESOP

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ESOP's share of S Corporation's distributions during the loan period. This is "free cash" the ESOP can use to make loan payments**

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Total company tax "subsidy" from funding transaction with an ESOP

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Interest savings from loan prepayment with S corporation distributions to ESOP

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Net cash cost of financing transaction after ESOP tax "subsidy"

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Cost Difference

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Company's tax subsidy as a % of deal cost

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Basis recovery

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Tax-deferred proceeds to seller with a 1042 rollover (only available if company revokes S election or is already a C corporation)

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After-tax proceeds to seller without a 1042 rollover

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Total supplemental S Corporation cash distributions to the seller in the 5-year period after the transaction****

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After-tax interest paid on seller note (if seller-financed)

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Stock account of family members participating in the ESOP (not available with 1042 election)***

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Total value to seller and family

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Proceeds difference

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Comparison of Tax Benefits and Costs, S corporation

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Total principal and interest cash cost to the company*

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Tax savings from deducting principal on the loan by funding via the ESOP

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ESOP's share of S Corporation's distributions used to pay off the loan. This is "free cash" the ESOP can use to make loan payments**

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Total company tax "subsidy" from funding transaction with an ESOP

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Interest savings from loan prepayment with S corporation distributions to ESOP

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Net cash cost of financing transaction after ESOP tax "subsidy"

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Company's tax subsidy as a % of deal cost

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Basis recovery

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Tax-deferred proceeds to seller with a 1042 rollover (only available if company revokes S election or is already a C corporation)

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After-tax proceeds to seller without a 1042 rollover

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5 years of "supplemental distributions" to seller (only available if company does not revoke S election; after revoking S election, 5 year wait to re-elect)

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After-tax interest paid on seller note (if seller-financed)

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Stock account of family members participating in the ESOP (not available with 1042 election)***

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Total value to seller and family

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Compare the Cost to Company of Seller Stock Redemption Without an ESOP

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Total cost to the company using taxable dollars

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Annual cost to the company using taxable dollars

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Total Tax Advantage

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Disclaimer:

This calculator is for your information only. It is intended to inform you of the tax benefits of an ESOP. There are many forms of an ESOP transaction that will affect your actual transaction tax benefits.

It is not a solicitation or an advertisement for legal services. It is not a request for legal or tax advice. It does not create an attorney client or consulting relationship with Employee Benefits Law Group pc. You will not be contacted if you use this calculator unless you request it. Your privacy is important and we respect that. Your data is automatically deleted from our web server and is not retained beyond your session.

How Will It Work for You?

Your Information & Inputs

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Transaction Values

Bank to Company Loan Amortization

Seller Note Loan Amortization

Potential Results of an S Corporation ESOP Transaction

Potential Results of a C corporation ESOP transaction

Comparison of Tax Benefits and Costs, C corporation

Comparison of Tax Benefits and Costs, S corporation

Compare the Cost to Company of Seller Stock Redemption Without an ESOP

Disclaimer:

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