Employee Stock Ownership Plans (ESOPs): Tax Considerations in Plain English

By Stanley Rose December 1, 2013

Co-authored by Karl Heafield

An Employee Stock Ownership Plan (ESOP) is an entity that allows for the ownership of a corporation by its own employees.  There are many reasons for the use of an ESOP, including tax savings by the underlying corporation and motivation of its employees through “skin in the game.”  There are some truly unique tax rules, though, that individuals interested in forming an ESOP must understand.  The purpose of this article is to provide an overview of the function, benefits (and possible detriments), accounting and primarily the tax impact of ESOPs.  Although somewhat long, it is not intended to be comprehensive (the rules are voluminous and complex), but instead share enough information that its readers will know whether such an arrangement may be worth investigating further.

General background

An ESOP is a tax-qualified deferred compensation plan formed as a trust.  It originates and remains affiliated with a specific, sponsoring corporation – primarily through the ESOP’s whole or partial ownership of that corporation.  It provides several tax-beneficial qualities and involves participation of corporate employees, and for these reasons, both the IRS and the Department of Labor share jurisdiction over many of its features, as is the case with, for example, the more familiar Section 401(k) plan.

Employees are essentially beneficiaries of the trust, and assets such as cash are contributed to it and allowed to “build up” tax-free for the benefit of the participating employees.  The primary purpose of an ESOP, as its name implies, is for the trust to hold stock of the sponsoring company on behalf of the employees.  Indirectly, they own shares of the company stock.  The ESOP can hold all or part of the company’s outstanding stock, and can incur debt to acquire that stock.  Some of the holdings of the ESOP are allocated to participant employee “accounts” within the ESOP, while other holdings are held in a general account of the ESOP, to eventually be allocated to participant accounts, pay down debt used to acquire shares, buy shares from retiring or terminated employees, or simply be held for investment.  While the ESOP is expected to primarily hold stock of the sponsoring corporation, it also can hold cash or other investments.  Some diversification requirements exist that allow participants aged 55 or older who have provided at least 10 years of service to direct the investments of 25% to 50% of their account balances into assets other than company stock.

ESOPs are administered by a fiduciary, which can be an employee or an independent individual or group.  The fiduciary is responsible for establishing the value of shares held by the ESOP.  This value impacts lenders, the accounting of the sponsoring corporation, and participant accounts.  An independent, qualified appraiser should be engaged for this purpose.

The trustee annually will file a Form 5500 to report activity and information of the ESOP.  Generally ESOPs with 100 or more participants must accompany the Form 5500 with audited financial statements.

Generally all non-highly compensated 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.  As a qualified plan, it is subject to common ERISA nondiscrimination rules that prevent disproportionate favoring of highly compensated individuals.  Participants who have stock allocated to their accounts are entitled to voting rights on those shares if the sponsor is publically traded, but participants in private companies usually can vote only on matters of great significance, like the sale of a business.  Generally, the plan fiduciary holds voting rights for ESOP shares in all other cases, including those shares held by the ESOP but not allocated to participant accounts.

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.

An employee does not have free access to his or her ESOP account; the trust agreement will restrict that, again much like a 401(k) plan.  An employee who leaves the company or retires nearly always will find that the company stock will be exchanged for cash within the trust, pursuant to the trust agreement, prior to being paid to the departing employee.  (This common provision prevents stock from being held too widely, or held by someone no longer affiliated with the company, or worse – in the case of an S corporation – at risk of being transferred to a disqualified shareholder that may cause the company to lose its S election.)  Once reduced to cash, the employee can choose to have the holdings paid to the employee or “rolled over” into another qualified plan or IRA of the employee’s choosing.  If not directed to another IRA or qualified plan, the receipt of funds will result in taxable income at that time.  If the employee has not reached retirement age (59 ½ years), an additional federal penalty tax of 10% can be expected too.

In certain circumstances, ESOP participants may receive dividends from an ESOP or directly from the sponsoring corporation.  Such dividends will 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.

Tax impact on ESOP

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 (contributions and distributions into it, and increases in value) become taxable to anyone.

Tax impact on sponsoring corporation

Readers should be familiar with the concept of a “leveraged ESOP” to understand much of this section.  A leveraged ESOP is one in which the ESOP, or sometimes its corporate sponsor, borrows money to fund the purchase of shares by the ESOP from the company.  In a common scenario, the ESOP is formed, and it borrows money from a bank.  The money is then paid to the company for issuance of new shares or to its shareholders to acquire existing shares.  The sponsoring company will make periodic contributions of cash to the ESOP to allow it to repay the bank.

Readers also must be aware of the distinction between contributions to an ESOP and equity distributions paid to corporate shareholders, including the ESOP.  These two primary methods that corporations use to transfer money to ESOPs are treated very differently for tax purposes.

Contributions

As is the case with other qualified plans, amounts contributed to an ESOP are tax-deductible by the sponsoring corporation, subject to certain limits and an impressive array of exceptions that sometimes reduce, but sometimes increase the general limit.  Generally, the limit is 25% of “eligible pay,” with the contribution capped at $51,000 per participant.

There are ways to contribute more, though.  First, note that the 25% limit addresses corporate funding, but employee deferrals into Section 401(k) plans do not count against this cap.  For 2014, this could allow another $17,500, but both amounts combined are subject to the $51,000 cap.  Employees aged 50 or above can exceed the $51,000 cap and the 25% cap by deferring an additional $5,500 “catch-up” contribution.  However, for employees also participating in other defined contribution plans such as Section 401(k) plans, the employer contribution cap of $51,000 must be shared among all of these plans.

A second way of contributing more is available only to C corporations, but not S corporations:  In applying the above 25% limit, the portion of contributions by C corporations that is used to repay the interest portion of a leveraged ESOP’s loan does not count against the limit.  The deduction in that case may greatly exceed 25% of payroll.

Distributions

Distributions are not deductible by S corporations.  However, under certain circumstances, distributions (dividends) paid to ESOPs may be deductible by sponsoring C corporations.  To qualify, the dividends first must be “reasonable” in amount, and that term is not defined in the law.  (Presumably a dividend rate comparable to those paid by similarly sized or profitable companies would qualify; ones that greatly exceed that might not.)  Once that vague hurdle is crossed, the company can qualify for a dividend deduction in any of three ways.  One method is by paying the dividend to the ESOP participants directly, or through the ESOP, which then has 90 days from the end of that plan year to turn the cash over to the participants.  Another method involves dividends that are paid to a leveraged ESOP, but only if the cash is then used by the ESOP to pay down the loan used to acquire the shares covered by that distribution.  The final method includes dividends paid to the ESOP that are then used by the ESOP to reinvest in more shares of company stock.

Tax impact to corporate shareholders who sell shares to 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.  There are two primary requirements:  First, after the transaction, the ESOP must own at least 30% of the company stock in total.  (It is not necessary for 30% of the company stock to change hands during that particular transaction, and it is not relevant how many shareholders are involved with the transaction.  As long as the ESOP owns at least 30% by the end of the transaction, that transaction will meet this criterion.)  Also, the shareholder must reinvest the proceeds into “qualified replacement property.” Generally, unrelated corporate stock of any trade or business will meet this definition, but sellers usually use this opportunity to diversify into the publicly-traded stock market.  This reinvestment must take place in the 15-month period ending one year after the sale to the ESOP.

This benefit may only defer the tax until the new replacement securities are sold (rather than avoid it permanently).  It does so by assigning the shareholder’s cost basis in the previous holdings (the shares of the sponsoring company that are transferred to the ESOP) to the replacement holdings – regardless of the new property’s actual acquisition cost.  This “locks in” the gain, which will be triggered any time the shareholder sells the replacement property.  Note, though, that if the shareholder leaves those new holdings to his or her heirs via a will, the inherited holdings will then be assigned a basis equal to current market value as of the date of death, and the income deferral may then be made permanent.

Here is an example:  Let’s assume that many years ago a shareholder bought shares of the sponsoring company for $30,000.  This year in a qualifying transaction, he sells those shares to the ESOP for $100,000 and reinvests that $100,000 in various blue-chip securities.  The $70,000 gain ($100,000 – $30,000) is not currently taxable, but the potential for gain is preserved because he must assign a cost of only $30,000 to the new holdings that he just purchased for $100,000.  Continuing the example, if he sells the replacement holdings later for $120,000, his gain will be $90,000 ($120,000 – $30,000).  However, this income deferral can be made permanent if he leaves the replacement securities to his heirs instead of selling them.  In that case, if the value is $120,000 when he dies, his heirs receive them with a cost basis of $120,000, and can sell them for that amount without incurring any gain.  In fact, income tax on the gain was never incurred by anyone.  (This benefit does not immunize the holdings from any otherwise-applicable estate tax.) 

You can see from these examples that the shareholder diversified his holdings using an ESOP, and either deferred or escaped all income taxation on the sale.  This is a very unusual benefit.  In other tax scenarios, certain property swaps can produce income deferrals (such as so-called “like-kind exchanges”) as long as cash is not even temporarily received.  However, it is truly rare that taxpayers can defer gain when they actually get their hands on the cash, and this is one such example.

Shares acquired by the ESOP in a deferral transaction like this cannot be allocated to the selling shareholders’ ESOP accounts, certain family members’ accounts, or accounts belonging to 25% owners of the company.

Accounting for ESOPs – in general

Accounting for non-leveraged ESOPs is relatively straightforward.  Generally contributions are deductible and distributions are treated as a decrease in equity.  It is only when a leveraged ESOP is in use that accounting takes a turn for the surreal.  In nearly every leveraged ESOP arrangement, the sponsoring company will guarantee the loan or commit to the bank that it will routinely fund the debt payments via contributions or distributions to the ESOP.  Often some of the shares held by the ESOP are maintained in a suspense account (not allocated to participant accounts) to serve as collateral for the loan.  In those leveraged ESOPs, part or all of the ESOP’s debt must be recorded as debt of the sponsoring corporation for accounting purposes.  A corresponding contra equity account is established that reduces equity of the corporation.  Both of these balances are relieved as the debt is repaid.  Also, the company records deductions (for accounting purposes only – not for tax purposes) equal to the value of shares released from collateral and allocated to participants accounts.

These accounting rules can cause the financial statements of a sponsoring company to appear dramatically weaker and more complex than they were prior to engaging in a leveraged ESOP (although this weakening seems appropriate if the company is on the hook for the ESOP’s debt).  The company may be best served by dealing with sophisticated lenders who are proficient with accounting for ESOPs, and by explaining these changes with other interested parties who have access to the financial statements.

Who should use an ESOP?

There are some clear pros and cons inherent in ESOPs, as well as some planning opportunities and other considerations that might fall into the “it depends” category.

Pros

1. ESOPs can motivate employees simply by giving them a piece of the pie.  However small, an increase in the company’s stock value results in an increase to the participant’s account value.  This can provide motivation unmatched by a paycheck.  Indirectly, the company belongs to its employees, and their performance can impact its value.
2. Like any other qualified plan, the ESOP allows transfer of assets (usually cash) in a manner that results in a current deduction for the company but without immediate inclusion in the participant’s income.
3. Subject to limits described elsewhere, tax deductions are available (indirectly) for payments of debt, including principal.
4. Unlike other qualified plans, ESOPs can incur debt to acquire their holdings, and can do so by borrowing from the sponsoring corporation.
5. For certain C corporation shareholders, gain can be deferred from sale of shares to an ESOP, thereby allowing the shareholder to diversify her holdings dollar for dollar, instead of net of tax.  This is a great asset protection vehicle, especially for those shareholders nearing retirement.

Cons

1. ESOPs are expensive to form.  They require the help of attorneys who are familiar with both DOL and IRS rules, a plan administrator and business valuation experts.
2. ESOPs are expensive to administer.  Annual fees for a third party administrator, preparation of Form 5500, and (depending on number of participants) a financial statement audit can be expected.  While these may be comparable to costs of maintaining any qualified plan, the additional cost of an annual appraisal is unique to ESOPs.  Also, sufficient cash must be maintained in the ESOP to fund the buyout of departing employees or meet diversification requirements, both of which can cause ESOPs with many retirement-age participants to need regular influxes of cash.  For S corporation sponsors partially held by ESOPs, distributions to taxable shareholders (even those intended simply to cover shareholder taxes) must be matched proportionately with a distribution to the ESOP.  This distribution is not deductible by the company.  For companies with limited free cash, this may cause a planned deductible contribution to the ESOP to instead take the form of a nondeductible distribution.  This in turn drives up income for the company, thereby creating the need for even higher tax distributions.  Profitable S corporations that are heavily leveraged outside of the ESOP may struggle to coexist with the ESOP for this reason alone.
3. Formerly private financial information will in some level of detail be available to employee participants.
4. Relative to other retirement vehicles, employee holdings are less diversified.
5. Financial statement accounting for leveraged ESOPs can be confusing and cause the company to appear to have weakened with the inception of the ESOP.
6. As discussed below, closely-held S corporations with ESOPs are at risk of some unusually stiff consequences if allocations are made to participants who hold too much stock.

Other considerations/planning

Some types of cash infusions into the ESOP will benefit one category of employees over another.  As discussed above, corporations generally get cash to the ESOP in one of two ways: contributions or distributions from equity.  These alternatives impact recipient accounts very differently.  Contributions generally are allocated pro-rata to ESOP participants based on their current compensation.  Distributions are allocated based on the number of shares held in participant accounts.  The distributions, therefore, favor those who have built up value in their accounts over time, while contributions favor new employees with high income, such as recently-hired executives or promoted employees.

Severe restrictions for closely-held S corporation ESOPs

All ESOPs are subject to ERISA nondiscrimination rules that apply to a number of qualified plans.  S corporation-sponsored ESOPs, though, are subject to another rule designed to prevent narrow concentration of ownership, and the consequences of violating it can be severe.  The rule is frustratingly complex, and cannot be stated succinctly without elaborating because of so many definitions and exceptions.  In general, it prohibits a group of disqualified persons from collectively owning 50% or more of the company, including allocated ownership through the ESOP.  The existence of this rule (and the consequences of violating it) should cause closely held S corporations that are considering an ESOP, or those with very few employees, to proceed with caution.

To determine whether a violation has occurred, two steps are required:

1. Determine who is a disqualified person.
2. Determine whether disqualified persons collectively own at least 50% of the company.

Both of these steps involve percentages and fractions, but the denominator differs between the two steps.

A disqualified person is one who owns 10% (or with family members owns 20%) of “deemed-owned” shares.  Deemed-owned shares include shares allocated to that person’s ESOP account, a proportionate number of shares held by the ESOP that have not yet been allocated to participant’s individual accounts, and “synthetic equity” held by that person outside of the ESOP.  Synthetic equity includes things like stock rights or even rights to acquire assets in a related entity.  Any synthetic equity deemed to be held by a participant is decreased proportionately if the ESOP owns less than 100% of the company.  Note, however, that deemed-owned shares do not include stock held directly by that person outside of the ESOP.  To be clear, the deemed-owned denominator does not include all the outstanding stock of the company, because it does not include stock held outside the ESOP.  However, the denominator is not limited to stock actually held by the ESOP, because it is expanded to include a portion of “synthetic equity.”

Each person who owns 10% of the deemed-owned shares described above is tainted as a disqualified person, and moves on to round 2 of the test, where the numerator and denominator expand to include all deemed-owned shares, all synthetic equity (not just the ESOP-owned portion) and all “outside” shares (stock held outside the ESOP).  If the group of disqualified persons collectively own at least 50% of the company under this part of the test, the test is failed.

If the test is failed, it unleashes a very unpleasant set of consequences:

1. The values of allocations to accounts of disqualified persons are treated as taxable distributions.  Recipients who are not yet age 59 ½ incur a 10% penalty in addition to the tax.  To make matters worse, the tax and penalty are assessed even though the person never received cash, leaving the person to pay these charges using other means.
2. The company is subject to a penalty of 50% of the value of deemed-owned shares held by disqualified participants and 50% of the value of their synthetic equity.
3. The ESOP may lose its status as a qualified plan, which would at a minimum cause its share of the S corporation’s earnings to become taxable as unrelated business taxable income.
4. If the ESOP is leveraged with a loan from the sponsoring corporation, the loan will be subject to an excise tax because the loan will be characterized as a prohibited transaction.

Obviously, violations of this rule should be avoided at all costs.  Tax rules appear to provide a way to avoid prohibited allocations by use of a separate, non-ESOP portion of a qualified plan to hold otherwise prohibited shares, but such arrangements would subject that portion of S corporation earnings to an “unrelated business taxable income tax,” and require extensive monitoring – all with the risk of nasty consequences for any misstep.  This rule makes ESOPs a relatively unattractive option for S corporations that are closely held or that have very few employees.

Conclusion

ESOPs are at the same time both simple and complex, with the potential to both punish and reward.  They have much in common with other more familiar qualified plans, but are unique in their ability to hold related corporate stock and borrow money.  They can be incredibly useful for a retiring shareholder of a closely-held C corporation, who can diversify and defer significant gain and taxes on the sale of shares to the ESOP. Meanwhile, ESOPs must be handled with care by closely-held S corporations, who together with participants and the ESOP itself must be constantly mindful of some stinging penalties applicable to prohibited allocations.  ESOPs can require a lot of cash to maintain, but in exchange provide some unique and significant tax savings that can exceed those of other plans, like the ability to deduct certain dividends and indirectly, principal payments.  ESOPs deserve consideration for a number of reasons, and hopefully this article provides its readers with enough information that they will know whether such a plan is worth pursuing.

If you have any questions or would like to discuss this information further, please contact Karl Heafield or your BNN advisor at 1-800-244-7444.