Tax Incentives for ESOPs
Tax-Deferred Sales of Company Stock
A shareholder of a “closely-held” C corporation may sell company stock to an employee stock ownership plan and trust (“ESOP”) and defer the taxation of gain to the extent that he or she reinvests in securities of other corporations (“replacement securities”). The sale must be one that would otherwise result in long-term capital gain to the shareholder, the shareholder’s holding period for the stock must be at least three years and the shareholder must not have received the stock from a qualified employee plan (such as an ESOP), by exercising a stock option or through an employee stock purchase program. The replacement securities must be purchased within the 15-month period that begins three months before and ends 12 months after the sale of company stock to the ESOP. The replacement securities must be securities of unrelated U.S. operating companies whose passive investment income does not exceed 25% of gross receipts. After the sale, the ESOP must own (in a fully diluted basis) at least 30% of the common equity of the employer that sponsors the ESOP. The employer must consent to the election of tax-deferred treatment, and a 10% excise tax is imposed on the employer for certain dispositions of stock by the ESOP within three years after the sale. The stock that is purchased by the ESOP may not be allocated to the seller, certain members of his family or any shareholder who owns more than 25% of any class of company stock. A prohibited allocation causes a 50% excise tax to be imposed on the employer and adverse income tax consequences to the participant receiving the allocation.
Deduction for Dividends Paid to ESOP Participants
A tax incentive is provided for “passing-through” dividends on company stock to ESOP participants. A C corporation will be permitted to deduct the amount of cash dividends paid on company stock held by an ESOP to the extent that participants (or beneficiaries) currently receive the dividends. The dividends must either be paid directly to participants or be paid to the ESOP and distributed to participants (or beneficiaries) within 90 days after the end of the plan year in which the dividends are paid. The dividends will be fully taxable to participants (or beneficiaries), but will be exempt from income tax withholding. The deduction is allowed for the taxable year in which the dividends are paid to participants (or beneficiaries). For taxable years beginning after December 31, 2001, this deduction is now also available for dividends that, at the election of ESOP participants (or their beneficiaries), are paid to the ESOP and reinvested in company stock.
Deduction for Dividends Applied to Loan Payments
A C corporation may deduct the amount of cash dividends paid on company stock held by an ESOP and purchased with the proceeds of an ESOP loan (both allocated and unallocated shares) to the extent that the dividends are used by the ESOP to make payments (of principal and/or interest) on that ESOP loan. Special ESOP allocation rules may apply when dividends on allocated shares are used to make loan payments. The deduction is allowed for the taxable year in which the dividends are used for loan payments. This provision significantly enhances the ability to finance ESOP transactions on a pretax basis.
Tax-Deductibility of ESOP Contributions
Employer contributions to an ESOP are currently tax deductible, subject to certain limits under the Internal Revenue Code of 1986, as amended (the “Code”). Contributions to an ESOP generally may be deductible in amounts up to 25% of covered payroll (i.e., the covered compensation of all participants eligible to receive allocations under the ESOP). Contributions in the form of company stock are deductible based upon the current fair market value of the shares. For a leveraged ESOP, an additional deduction of up to 25% of covered payroll in a C corporation may be allowed for contributions used to make principal payments on an ESOP “acquisition loan” (i.e., a loan incurred to acquire qualifying employer securities); provided, however, that the contributions deducted under the first 25% are not applied to acquisition loan repayments. Contributions used to pay interest on an ESOP acquisition loan are fully deductible (and not limited by covered payroll) so long as not more than one-third of the ESOP contributions are allocated to “highly compensated employees”, and the plan sponsor is a C corporation.
S Corporations ESOPs
Under current law, as enacted in 1997 for years beginning on or after January 1, 1998, S corporation ESOPs are exempt from the unrelated business income tax (UBIT); thus, if an ESOP owns all of an S corporation, no current tax is imposed on the company’s income. (That income is eventually taxed because ESOP participants in S corporations are taxed on ESOP distributions, just as C corporation ESOP participants are.) The Economic Growth and Tax Relief Reconciliation Act of 2001, as amended, restricts the abuse of this provision by plans designed to benefit only a small number of employees, whether in a very small company or where a small number of employees set up an S corporation ESOP to benefit themselves while operating a larger company whose employees are not covered by the ESOP. The U.S. Treasury and the IRS issued Temporary and Proposed Regulations regarding S Corporation ESOPs on July 18, 2003, revised such regulations on December 17, 2004, and issued Final Regulations regarding S Corporation ESOPs on December 20, 2006.
Effective for S corporation distributions made after December 31, 1997, the Code that permits S corporation ESOPs to apply such S corporation distributions received on qualifying employer securities (whether allocated or not) to make acquisition loan repayments, provided, however, that the plan document provides that “employer securities with a fair market value of not less than the amount of such distribution are allocated to such participant for the year which [otherwise] would have been allocated to such participant.” S corporations, however, still are not entitled to deduct such distributions.
Unless an ESOP participant has reached age 70 ½, distributions of vested benefits from the ESOP to participants (or their beneficiaries) are considered eligible rollover distributions. If the ESOP participants (or beneficiaries) elect to roll over their distribution of vested benefits to an individual retirement account or annuity (an “IRA”) or another eligible retirement plan, such distribution recipients are not taxed on the distribution from the ESOP until they later receive such funds from their rollover institution. If ESOP participants roll over their distribution to a Roth IRA, the distribution is includible in their gross income for the year of receipt, however, the ESOP is not required to withhold income tax amounts from the distribution. Since 2004, the IRS has ruled that a rollover to an IRA of S corporation qualifying securities distributed from an ESOP will not involuntarily terminate the S election.