How Does an ESOP Work?

Updated October 2019. The original article was updated for clarity and relevance.
An ESOP is an employee benefit plan which, through a trust, owns stock in your company for the benefit of the employees. It is seen as a great motivating tool for employees to be more productive and to share in the wealth of your company. For companies, it can become a method of lowering tax burdens. For owners, it is a means to sell their interest often at a great tax advantage and on their own timeframe.

An ESOP is one of the only business transition tools that allows an owner to sell their interest in their company over time or all at once. An ESOP can work in conjunction with other succession planning techniques. You can decide to retain an ownership interest for yourself, sell ownership interests to management, gift ownership interests to your kids and still sell an ownership interest to an ESOP.

ESOP Contributions

Contributions to ESOPs can be tax deductible. There are limits, as with most plans. If an ESOP is leveraged, the deductibility may be even higher. With leverage, the ESOP or its corporate sponsor borrows money from a bank or other qualified lender. The company typically guarantees that it will make needed contributions so the trust can repay the loan. A company can potentially deduct from taxable income both principal payments and interest payments. Dividends paid on ESOP stock passed through to employees or used to repay the ESOP loan may be tax deductible.

S-Corporation ESOPs

A further advantage exists for an ESOP in an S-corporation (where profits are passed through to the shareholders via a K-1). As a tax-exempt entity, the ESOP pays no federal (and possibly local) income taxes on its share of the sponsor’s income. In a 100% ESOP owned S-corporation, there are no federal corporate taxes due.
For the employee, federal income taxes are paid when ESOP participants receive a distribution from the retirement plan. The same tax advantages and rollover opportunities that are available on distributions from all other types of qualified retirement plans like 401(k)s are available with ESOP distributions.

C-Corporation ESOPs

Owners of closely held C-corporations can sell their stock to the ESOP and defer federal income taxes on the gain from the stock sale. However, there are additional requirements that must be met. The ESOP must own at least 30% of the company’s stock immediately after the sale and the seller must reinvest the proceeds in securities of domestic operating companies within a set timeframe. Other restrictions exist.

Considerations for ESOPs

An ESOP is not for everyone. ESOP implementation and maintenance can be costly. A properly designed plan using qualified professionals can mitigate these costs. Annual filings with the IRS and the Department of Labor are required. As with any legal entity, attorneys who are expert in this area should maintain up-to-date paperwork. An outside administrator will send benefit statements to employees, file the various regulatory papers and answer questions from your employees. An annual valuation is also needed.

An attorney and an ESOP specialist should design the Plan with your guidance to avoid any legal or tax consequences. Click here to access the professional association’s website The ESOP Association.

At JBV, we are here to assist with any of your ESOP or transition planning needs. If you have questions, please don’t hesitate to contact us.