- Ask the Experts!
The professionals at Advanced Underwriting Consultants (AUC) answer the tax questions posed by producers. Here’s the question of the day.
Question: What is an Employee Stock Ownership Plan (ESOP)?
Answer: An employee stock ownership plan (ESOP) is a special kind of defined contribution retirement plan that can help closely-held business owners solve succession issues. Where it fits, an ESOP offers substantial advantages over traditional buy-sell planning. The main advantage is that the business owners and the company are able to fund a buyout with pre-tax money.
Unlike other retirement plans, an ESOP is required to invest primarily in the sponsoring company’s securities. Most often, the securities take the form of the company’s common stock.
To set up an ESOP, the sponsoring company first needs to create a pension trust, into which shares of the company stock will go.
The employer might contribute new shares of its own stock into the trust, or it may contribute cash to buy existing shares. The ESOP plan might be empowered to borrow money to buy additional shares, with future employer contributions anticipated to repay the loan. If the ESOP trust borrows money to buy shares, it can borrow funds backed by the credit of the sponsoring company. Further, company contributions to the ESOP trust are deductible, both for the loan principal and loan interest.
Shares owned by the trust are in turn allocated to individual employee accounts, as with most kinds of defined contribution plans. Plan allocation formulas must not discriminate in favor of highly compensated employees, and are typically based on employee compensation.
When an employee leaves the company, the employee receives either the stock from the employee’s account, or an amount of cash equal to the value of the stock. If stock is distributed, the plan document requires the company to buy back ESOP stock from the employee at its fair market value.
Distributions from ESOPs are generally taxed the same way as distributions from other qualified plans. For example, distributions prior to age 59½, death, or disability are usually subject to a 10% penalty. ESOP distributions, when turned into cash, are generally eligible for rollover.
In addition to the tax deduction generated, the ESOP also offers extra tax advantages to owners of closely held C corporations. Most shareholders of C corporations can sell stock to the ESOP, and reinvest the proceeds, with all taxes deferred, by making a Section 1042 election.
The C corporation owner can elect to defer capital gains tax on stock sold to the ESOP if
- After the sale the ESOP owns 30% or more of all outstanding stock; and
- The seller reinvests an amount equal to the sale proceeds into qualified replacement property, during the period beginning three months before and ending twelve months after the sale to the ESOP.
Not all eligible owners of C corporations will elect tax deferral under Code Section 1042. Making the choice will depend on a variety of factors, including the seller’s current and expected future capital gains tax rates.
Have a question for the professionals at AUC? Feel welcome to submit it by email. We may post your question and the answer as the question of the day.