When company leadership considers whether an ESOP is a good fit, they must carefully consider the pros and cons of the decision, including how transitioning to an ESOP may impact a company’s tax obligations — and how ESOP taxation rules may provide a competitive advantage to the company.
The portion of a company owned by an S corporation ESOP is not subject to federal or state income taxation.
This means that an S corporation that is 100% ESOP-owned is not subject to any federal or state income taxes.*
On a practical level, in terms of running the business, this primary tax benefit of an ESOP can result in increased cash flow — a clear competitive advantage for the company.
To further clarify, in this article, we’ll address some of the initial questions that often arise around the subject of ESOP taxation, including:
- Is an ESOP plan taxable, or is it tax free?
- Who benefits from ESOP taxation rules?
- How do ESOP tax advantages work?
- Does an ESOP company still have to pay taxes?
What is an ESOP?
An employee stock ownership plan (ESOP) is a business transition tool, an employee ownership vehicle, and a qualified retirement plan.
Most often, departing owners of profitable, closely held companies choose an ESOP as an exit strategy as they transition toward retirement. An ESOP creates a way for the owner to get the benefit of selling the business while maintaining company control, upholding company culture, and extending ownership benefits to employees.
In short, the company sets up a trust and contributes shares (or cash to buy shares) into the trust. That cash can be borrowed from a bank, in the case of a leveraged ESOP. Within certain limits, company contributions to the trust are tax-deductible.
Those shares of company stock in the ESOP trust are allocated to individual employee accounts according to a formula determined by the ESOP, typically based on pay, seniority, or more equal factors. As employees remain with the company, their right to the value of shares in their account increases until they are 100% vested.
When employees leave the company, the company purchases their stock allocations back from them at fair market value — as determined by an annual valuation performed by an outside third party.
Is an ESOP right for you? Take the Quiz.
You can get a deeper understanding, and evaluate whether an ESOP may be the best fit for your organization.
How are S corporation ESOP companies not subject to income taxation?
It’s important to understand that an ESOP company’s tax-exempt status does not mean that employees don’t pay taxes. There’s a significant difference between tax-free and tax-deferred.
S corporations are pass-through entities. This means that they 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.
What does that mean?
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.
What are the benefits of an ESOP’s federal and state income tax-exempt status?
The exemption from federal and state income taxes creates a powerful tax advantage that provides the cash flow for an ESOP to purchase the company from the selling shareholder(s).
In addition, once the stock purchase has been completely funded, the 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?
No. In short, ESOP tax advantages are intentional — not an oversight error.
If you review the above-mentioned legislation, you can 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.
Studies demonstrate better performance, higher compensation, and other positive outcomes among ESOP companies. Those benefits may translate into greater wealth distributed among more individuals — and that in turn may lead to increased overall tax revenues and fewer individuals’ reliance on government-funded entitlement programs.
How can the government afford the ESOP tax benefits? Doesn’t the IRS stand to lose revenue?
It is important to note that the tax advantages are essentially a tax deferral, not tax avoidance. As a qualified retirement plan, an ESOP is recognized by the IRS as a retirement plan that allows income to accumulate tax-deferred.
So ultimately, ESOP employees pay taxes when they receive their distributions.
In addition, an S corporation ESOP company actually has the effect of increasing individual tax collections from both employees and employers.
How? 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 regulate ESOP tax benefits to prevent abuse?
These tax benefits are significant, so to prevent abuse, 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.
Learn more about the potential business benefits of an ESOP
The tax advantages described here are just a few of the many potential benefits an ESOP can offer you and your employees over the process of the transaction — and well into the company’s future. Multiple studies indicate that ESOP companies perform well above medians for sales, productivity, and growth. Other demonstrated benefits include improved outcomes for employees of color, lower likelihood of going out of business, overall higher employee compensation, and more.
But is an ESOP really your best option? You can get a deeper understanding, and evaluate whether an ESOP may be the best fit for your organization, when you review our free quiz, Is an ESOP Right for Your Company?
*Is a 100% S corporation ESOP company exempt from ALL taxation?
No. The ESOP shareholder is a tax-exempt entity, 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 that income tax. For example, under California law, S corporations are subject to a 1.5 percent tax on their net income.