An ESOP Company Pays no Federal or State Income Taxes

Posted by Aaron Juckett, CPA, CPC, QPA, QKA on Tue, Jun 25, 2019
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The portion of a company owned by an S Corporation ESOP is not subject to federal or state income taxation, increasing cash flow and providing the company with a competitive advantage. 

This means that S Corporations that are 100% ESOP-owned are not subject to any federal or state income taxes, increasing cash flow and providing the company with a competitive advantage. 

Let me repeat:  S Corporation ESOP companies are not subject to federal or state income taxation!*

What is an ESOP?

An employee stock ownership plan (ESOP) is a business transition tool, employee ownership vehicle, and qualified retirement plan.

How are S Corporation ESOP companies not subject to income taxation?

S corporations are pass-through entities that pass through their corporate income to their shareholders for federal and state income tax reporting purposes. Each year the shareholders receive an IRS Form K-1 and report the flow-through of the income on their personal tax returns based on their individual federal and state income tax rates.

As a result of the Small Business Job Protection Act of 1996, ESOP trusts are IRC Section 401(a) exempt organizations permitted as S Corporation shareholders.

The ESOP trust is an S Corporation shareholder that is a tax exempt entity not subject to income taxes. The Taxpayer Relief Act of 1997 and IRC Section 512(e) repealed the application of unrelated business taxable income (UBTI) for ESOPs effective for taxable years beginning on or after January 1, 1998.  

This is a very powerful tax advantage that provides the cash flow for an ESOP to purchase of the company from the selling shareholder(s).  Once the stock purchase has been completely funded, the additional cash flow resulting from the tax savings provides a company with a cash flow competitive advantage over their non-ESOP counterparts.

Is this an unintended loophole in the Internal Revenue Code?

If you review the above-mentioned legislation you will see that the ESOP tax benefits are specifically cited in the legislation and are not an unintended consequence. Congress considers selling to an ESOP to be good public policy and has specifically created this benefit to further incentivize ESOPs and employee ownership.  

How can the government afford the ESOP tax benefits?

It is also important to note that the tax advantages are essentially a tax deferral, not tax avoidance.  An S Corporation ESOP company "increases tax collections from both employees and employers" as the additional value created by the tax savings generates additional federal and state income taxes in economic activity and because ESOP participants pay taxes on the additional wealth when their accounts are liquidated from the ESOP.  

How does the government prevent abuse of these ESOP tax benefits? 

To prevent abuse of these significant tax benefits, Congress established the requirements of IRC Section 409(p) Anti-Abuse Testing to help ensure that an S Corporation ESOP company provides broad-based ownership and coverage that benefits rank-and-file employees.

*Are S Corporation ESOP companies exempt from all taxation?

No.  The ESOP shareholder is tax exempt, not the corporation.  To the extent the corporation is directly subject to taxation, such as property taxes, the corporation is still responsible to satisfy the tax obligations.  In addition, if a state has an income tax on S corporations, the corporation is still responsible for the income tax.  For example, under California law, S corporations are subject to a 1.5 percent tax on its net income.

To learn more about the benefits an ESOP has to offer and whether one may be right for your business, download our tip sheet, Is an ESOP Right for Your Company?

Is An ESOP Right For Your Company?

Topics: ESOP Benefits, Selling to an ESOP

Aaron Juckett, CPA, CPC, QPA, QKA
Written by Aaron Juckett, CPA, CPC, QPA, QKA

Aaron is President and Founder of ESOP Partners and provides implementation, administration, and consulting services to hundreds of companies. He is a member of The ESOP Association (TEA) and the National Center for Employee Ownership (NCEO).

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