S corporation employee stock ownership plans (ESOPs) have been immensely popular with our clients since they were made possible in 1998 – and with good reason. S corporations that have elected to pass through their corporate taxable income to their shareholders under Subchapter S of the Internal Revenue Code, can now pass through their taxable income to a tax-exempt ESOP shareholder. Combining a flow-through S corporation tax entity with the tax-exempt trust of an ESOP allows the corporate income to be tax exempt on whatever share of the S corporation is owned by the ESOP. This combined corporate and retirement plan tax structure can actually yield a 100% tax-exempt, for-profit, employee-owned company.
ESOPs, as S corporation shareholders, are also entitled to their proportionate share of any cash distributions paid by the corporation, which are invested by the ESOP as dividends and are retirement plan earnings. Well-designed S corporation ESOP transactions have been able to fund between 30% and 60% of a transaction's cost with these real tax dollars saved by the ESOP. ESOPs can also use these tax dollars saved to help fund future ESOP benefit distributions and the expenses and costs of operating the ESOP.
Put all the proclaimed incentives together and 100% of the cash flow to fund an ESOP can be saved in the ESOP or the corporation. But these large incentives are often under-communicated and over-promoted because they have complexities, trade-offs and certain Internal Revenue Code strings attached. They require careful consideration to determine if they're the right incentives to meet a client's often multiple – and sometimes competing – objectives.
These plans sound ideal, but they're not for every company, despite the enormous tax efficiency. Objective guidance, from a trusted advisor, that fully understands the complexities of these comparisons, tax implications and sometimes trade-offs of each option is imperative. They require careful consideration to determine if they're the right combination of incentives to meet objectives, or to find alternatives, if necessary or better for the client.