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Ext. PublicationEmployee Stock Ownership Plan (ESOP) Tax Reference Guide
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An employee stock ownership plan (ESOP) is a tax-advantaged way to sell a business to the employees of a company.
4 minute read
April 13, 2022
Partner, Financial Advisory
ESOP and Valuation Services
ESOP and Valuation Services
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Employee Stock Ownership Plan (ESOP) – Selling Shareholder Tax Advantages
When you need an audit, a fairness opinion, or an annual valuation update for your employee stock ownership plan (ESOP), it’s important to find a team you trust. That’s why Weaver has built a team specifically focused on these plans.
- Section 1042 of the Internal Revenue Code allows for the deferral of federal capital gains taxes
- Eligibility requirements and considerations for the selling shareholder’s deferral of capital gains:
- C-corporation status
- Minimum of a 30% sale to an ESOP
- Reinvestment of ESOP sale proceeds into qualified replacement property within 12 months of the close of the ESOP transaction
- Qualified replacement property includes domestic stocks and bonds; additional financing products available for those who wish to get a loan against their domestic stocks and bonds portfolio in order to retain cash or invest in ineligible property
- Selling shareholder may not have received the C-corporation stock as part of an employee benefit plan or stock option plan
- Selling shareholder must have held the C-corporation stock for 3 years prior to the ESOP transaction
- Selling shareholder and certain family members are ineligible to receive allocated ESOP shares
- Many states allow for a similar treatment for state capital gains taxes
- No capital gains deferral is available to S-corporations
- Eligibility requirements and considerations for the selling shareholder’s deferral of capital gains:
Characteristics of a Good ESOP Candidate
| Shareholder Tax Implications | Stock Transactions | 1042 C-corp ESOP Transaction 1 |
|---|---|---|
| Sales Price | $50,000,000 | $50,000,000 |
| Basis | $5,000,000 | $5,000,000 |
| Capital Gain | $45,000,000 | $45,000,000 |
| Federal Income Tax at 20% 2 | $9,000,000 | $0 |
| Net Proceeds 3 | $36,000,000 | $45,000,000 |
1 IRC 1042 allows for the deferral of capital gains and may be deferred indefinitely.
2 Only federal income taxes considered for simplicity. State capital gains taxes may be deferred in certain states.
3 Non-ESOP or S-corp ESOP transactions have unencumbered net proceeds whereas the 1042 C-corp must reinvest in qualified replacement property.
S-Corporation ESOP Tax Advantages
- No federal income taxes as an S-corp is a pass through entity and an ESOP is a tax-exempt entity
- Most states treat ESOPs as state income taxexempt
- Principal payments on a ESOP loan are deductible
- May not utilize last in, first out method of inventory accounting
- Distributions are not tax deductible
- Contributions to the ESOP, in combination with any other qualified benefit plan, are deductible
C-Corporation ESOP Tax Advantages
- Dividends are tax deductible when utilized to repay an ESOP loan or paid to the participants
- Contributions may be deductible up to 50% for leveraged ESOPs. Contributions up to 50% of the total compensation of ESOP participants may be deductible based upon two buckets of 25% limitations:
- ESOP contributions for the repayment of the ESOP loan principal and interest; and
- Employer contributions to any other defined contribution plan or contributions not utilized for the repayment of the ESOP loan or interest
