Major Tax Benefits of ESOPs

Employee Stock Ownership Plans (ESOPs) serve as an essential tool for building long-term company stability and enhancing employee satisfaction. Beyond these perks, ESOPs offer unique tax advantages that can significantly boost a company’s savings and benefits. In this blog post, we’ll delve into these tax benefits while exploring ways to maximize your company’s savings through ESOPs.

Tax Advantages of ESOPs

The tax advantages which can be unlocked with ESOPs can be split into two groups: those for C corporations and those for S corporations:

ESOP Tax Benefits For C Corporations

As per Section 1042, C corporation companies with ESOPs can benefit in the following ways each tax year:

• Contributions for Loan Payments: Contributions used to pay ESOP loan interest are tax-deductible. Contributions used to repay ESOP loan principal can also be deducted from up to 25% of covered payroll.
• Additional Contributions: Non-elective contributions up to a further 25% of covered payroll can be deducted.
• Seller Tax Deferment: Sellers owning at least 30% of the company stock can defer taxation on their gains. They can reinvest the proceeds from the sale in other securities and continue to defer taxation.
• Dividend Deduction: Cash used to pay company stock held by an ESOP is deductible, so long as the dividends are used to repay the ESOP loan or are passed through to employees.

ESOP Tax Benefits For S Corporations

For S corporations, the benefits differ but are still advantageous:

• Tax Exemptions: Owners are not taxed twice on the ownership percentage held by the ESOP. Profits attributed to the ESOP are exempted from federal and sometimes state income tax. That means, for instance, that there is no income tax on 30% of the profits of an S corporation with an ESOP holding 30% of the stock, and no income tax at all on the profits of an S corporation wholly owned by its ESOP. Note, however, that the ESOP still must get a pro-rata share of any distributions the company makes to owners.
• Full Ownership Benefits: If an S corporation is 100% ESOP-owned, the ESOP shareholder is tax-exempt from federal income and most state income tax. However, ESOPs must provide broad-based employee coverage to prevent abuse, as per Section 409(p).

Maximizing Savings

Companies, especially C corporations, can buy convertible preferred stock to secure a stable stream of income for servicing the ESOP loan. Leveraged ESOPs are particularly beneficial as they allow the deduction of cash dividends and contributions to repay ESOP loans.

The exemptions permitted with ESOPs can minimize the taxes a company and an ESOP have to pay. This thus maximizes saving, allowing for further investment into the company via the excess cash flow which would otherwise not be there. 

Contribution Limits

While ESOPs offer incredible tax advantages, it’s important to note that all contribution limits are subject to certain limitations, as laid down by the Employee Retirement Income Security Act of 1974 (ERISA) and the Internal Revenue Code (IRC).

Source: National Center for Employee Ownership (NCEO)