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Home > Resources > ESOP > ESOP Tax Benefits: A Brief Overview

ESOP Tax Benefits: A Brief Overview

August 8, 2017 by Employee Benefits Law Group

ESOPs, like all investment vehicles, have certain tax considerations. We provide the guidance you need to understand ESOP’s tax features and benefits, and design your ESOP to best suit the needs of all parties involved. Here are some ways tax law can impact the various parties involved in an ESOP.

This is the third installment of our 4-part primer looks at ESOP’s tax benefits. In Part 1, we look at ESOP Basics. Part 2 discusses how to determine if an ESOP is right for you and your company. Part 4 discusses how many shares the owner should sell to the ESOP.

Owner

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A C corporation owner who sells stock to an ESOP that owns at least 30% of the company’s stock at the end of the transaction can defer tax on the gain from the sale by rolling the proceeds into a similar investment in U.S. operating company stocks and bonds (e.g., most publicly-traded stock on U.S. stock exchanges). This is known as a “1042 exchange.” Note that this option is not available to S corporation shareholders.

Participants

No tax is due when stock is credited to a participant’s account because the ESOP is a qualified retirement plan under the Internal Revenue Code. The participant will pay capital gain tax and income tax on distributions, plus a 10% penalty if the distribution is before normal retirement age. These taxes may be deferred by rolling distributions into an IRA or another retirement plan.

Corporations

Up to certain limits, corporations that offer ESOPs can deduct:

  • The value of stock they contribute to the ESOP.
  • Cash contributions the ESOP uses to buy stock.
  • Cash contributions the ESOP uses to make principal payments on a loan used to buy stock.

Generally speaking, the corporation can deduct a portion of the contribution – up to 25% of payroll. This limit applies across all of the employer’s defined contribution plans. In other words, if the employer has a 401(k) and an ESOP, the deduction for contributions to both plans cannot exceed 25% of payroll.

For C corporations, there is a separate 25% deduction limit for contributions to a leveraged ESOP that are used to pay down principal on the ESOP’s loan. An S corporation cannot take advantage of this separate 25% deduction limit. S corporations must also include in the deduction limit contributions that are used to pay interest on the ESOP’s loan in addition to principal payments.

Dividends paid on ESOP-owned shares are usually also deductible and are not subject to the 25% deduction limit.

ESOP

The ESOP trust is a tax-exempt vehicle that pays no tax on its income. This means that the ESOP’s share of the corporation’s income is tax-free in an S corporation because the corporation’s income is only taxed at the shareholder level and not at the company level like it is in a C corporation.

With the professional guidance from an ESOP expert at Employee Benefits Law Group, we can help you design an ESOP to maximize the tax benefits an ESOP can offer. Contact us to learn more.

Fourth In The Series: How Many Shares Should The Owner Sell To The ESOP?

Read our fourth blog post in this series outlining this decision-making process.

Learn More…

Filed Under: ESOP Tagged With: Blog

About Employee Benefits Law Group

Employee Benefits Law Group is a deep and diverse team of experts working to make your life easier and improve your outcomes in every aspect of employee benefits. Our clients know we listen, probe and understand their challenges and objectives. We ask the questions they didn't know needed to be asked. They count on us to deliver solutions that become part of their company's overall success.

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EDITOR’S NOTE: We did the best we could to make sure the information and advice in this article were current as of the date of posting to the web site. Because the laws and the government’s rules are changing all the time, you should check with us if you are unsure whether this material is still current. Of course, none of our articles are meant to serve as specific legal advice to you. If you would like that, please call us at (916) 357-5660.

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