What is an ESOP?
An Employee Stock Ownership Plan (ESOP) is a qualified retirement plan that allows for the ownership of a corporation by its employees. The ESOP Trust holds the stock of the corporation and the eligible Plan Participants share in the allocation of the stock within the ESOP.
What are some of the reasons for an ESOP?
There are many reasons for the use of an ESOP, including tax savings by the underlying corporation and incentivizing its employees through their participation. There are very detailed and complicated tax laws involved that individuals interested in forming an ESOP must understand.
Who utilizes ESOPs?
ESOPs are mostly used by shareholders of corporations who are interested in selling, thus realizing the equity in the business that has built up over their time of ownership. The ESOP can be the most tax efficient way to propel the sale. In the case of the ESOP, the selling shareholders are selling the company to the employees and not outsiders.
What is the primary purpose of an ESOP?
The primary purpose of an ESOP, as its name implies, is for the trust to hold stock of the sponsoring company on behalf of its employees. Indirectly, the employees become shareholders. While the ESOP is expected to primarily hold stock of the sponsoring corporation, it also can hold cash or other investments.
What is the role of a Plan Trustee?
An ESOP Trust must have a fiduciary (Plan Trustee) who is primarily responsible for establishing the value of shares held by the ESOP. This is determined using an independent, qualified business appraiser. ESOP Trustees are tasked with many other responsibilities.
Which employees must be included in an ESOP?
Generally, employees who have provided a year of service and reached the age of 21 must be covered by the ESOP. Specific minimum vesting rules must be followed.
What is the tax impact on employees?
The ESOP is a retirement vehicle for employees. Contribution of money and other assets to an employee’s account in the ESOP does not result in current taxable income for the employee. Likewise, increases in the account value occur tax-free. The holdings become taxable to the employee when later withdrawn from the ESOP (upon retirement or departure from the company) unless transferred to another retirement account.
In certain circumstances, ESOP participants may receive dividends from an ESOP or directly from the sponsoring corporation. Such dividends may result in current taxable income to the participant. Unlike “conventional” dividends that may qualify for favorable long-term capital gain tax rates, these dividends are taxed as ordinary income because they are treated as distributions from a qualified plan. However, they do not result in imposition of the early distribution 10% penalty tax.
IS THE ESOP SUBJECT TO TAX?
As a qualified plan, the ESOP generally is not subject to tax at all. This holds true even if the sponsoring entity is a Subchapter S corporation, which under tax laws sees its shareholders, rather than the company, subject to tax on corporate earnings. Receipt of cash contributions or equity distributions do not result in taxable income to the ESOP. It is worth noting that an S corporation’s income that is allocated to an ESOP (and it can be as high as 100% if fully owned by the ESOP) completely escapes current federal income taxation. Only when it is later paid out to ESOP participants do the ESOP holdings become taxable to anyone.
ARE CONTRIBUTIONS TAXABLE?
As is the case with other qualified plans, amounts contributed to an ESOP are tax-deductible by the sponsoring coporation.
WHAT IS THE TAX IMPACT ON CORPORATE SHAREHOLDERS WHO SELL SHARES TO THE ESOP?
A very attractive benefit is available to certain C corporation shareholders (but not S corporation shareholders) who sell shares of company stock to an ESOP. Generally, the shareholder is allowed to sell shares of corporate stock and avoid currently paying tax on the resulting gain if certain requirements are met. Internal Revenue Service Code 1042 governs these transactions.