Having a corporation as your business structure provides some beneficial options for tax planning as well as having a successor after you retire. One method that addresses both circumstances is forming an Employee Stock Ownership Plan (ESOP).
An ESOP permits employees to obtain stock ownership in the corporation to achieve a variety of purposes. ESOPs are most commonly used to provide a market for shares of owners who are retiring and want their companies to continue after their departures. An ESOP also is a method for motivating and rewarding employees, who have assurance of the business continuing after retirement of the primary shareholder—usually the founder.
A corporation with an ESOP sets up a trust fund that receives shares of stock for the employees. The company either contributes new shares or cash to buy existing shares. Alternatively, the ESOP may borrow money in order to purchase shares. In that case, the company makes cash contributions to the plan, which enables repayment of the loan. Regardless of how the plan acquires stock, company contributions to the trust are tax-deductible, within certain limits.
Shares in the ESOP trust are allocated to individual employee accounts—just like an employee retirement plan. Generally all full-time employees over age 21 participate in the plan, although there are some exceptions permitting exclusion. Allocations among employees are based upon either relative compensation or an equivalent formula. As employees accumulate more years working for the company, they become increasingly vested in the full rights of share ownership in their accounts. The ESOP may provide gradual vesting or all at once cliff vesting. Employees must become 100 percent vested within three to six years.
Private companies must have an annual independent valuation to determine the fair value of their shares. Employees have voting rights for their shares—particularly on major issues such as closing or relocating the business. When employees leave the company, they receive their vested shares of stock. The ESOP requires the company to repurchase these shares, unless there is a public market for the stock.
Departing employees can roll over their ESOP distributions to an IRA or other retirement plan. Otherwise, they owe income tax on the distribution of amounts contributed to the plan on their behalf. In addition, there is an extra 10 percent tax penalty for distributions before normal retirement age. However, any accumulated gain in share value is taxed at favorable capital gain rates.
Owners of privately held companies use ESOPs to create a market for the stock. The company’s tax-deductible contributions of cash to the ESOP are deployed to buy an owner’s shares. Contributions are subject to limitations, but these rarely pose a problem.
After an ESOP owns 30 percent of the shares in a company that’s a regular C corporation, the seller can defer tax on any gain by reinvesting the sale proceeds in similar small business stock.
For S corporations, an ESOP’s share of profit is not subject to federal income tax—and usually not state income tax. However, the ESOP still must receive its pro-rata share of any distributions the S corporation makes to shareholders.
An additional benefit of ESOPs is the ability of the plan to borrow money to purchase shares of stock. The company makes tax-deductible contributions to the ESOP to repay the loan. The consequence is that payment of both principal and interest on the loan is tax-deductible.