What are ESOPs?
An employee stock ownership plan (ESOP, or ESOPs, plural) is a tax-qualified, defined contribution, employee retirement plan designed to invest primarily in qualifying employer securities of the sponsoring corporation.
Generally, how does an ESOP work?
Qualifying employer securities of the sponsoring corporation, which are contributed to or acquired by the ESOP are allocated to the accounts of each eligible plan participant, and depending upon the manner in which the ESOP is designed, upon retirement, death, disability or termination of employment, each participant receives, in a lump sum or in installments, the vested portion of his or her ESOP account in stock, or if certain requirements are met, in cash equal to the current market value of the stock. If a participant receives a distribution in stock and the stock is not publicly traded, the participant will have the right during two 60-day periods to have the employer purchase the stock from the participant at the stock’s current value.
Are there any tax incentives associated with ESOPs?
Yes, Congress and the State of Iowa have created several major tax incentives designed to encourage the creation of ESOPs. The following are a few of the highlights:
Tax Free Rollovers of Gains by Shareholders on Sales of Stock to ESOP
If either before or as a result of the sale, more than 30% of the corporate sponsor’s stock is owned by the ESOP, and certain other requirements are satisfied, shareholders of corporation taxed as a “C” corporation who sell their stock to the ESOP can reinvest the sales proceeds in Qualified Replacement Property (e.g. stocks or bonds of domestic operating companies and banks) and defer payment of any taxes on the gain from the sale of their stock until they subsequently sell the Qualified Replacement Property.
Employer Tax Deductions for Contributions to ESOPs
Companies that sponsor ESOPs may deduct the value of their contributions to an ESOP.
Non-leveraged ESOPs – Cash Flow Advantages
For Non-leveraged ESOPs, a corporate sponsor may deduct the fair market value of its stock and cash contributions to an ESOP. If the corporate sponsor contributes stock to an ESOP it receives a deduction for a non-cash expense, thereby enhancing its after tax cash flow.
Leveraged ESOPs – Deductibility of Principal and Dividends
With respect to Leveraged ESOPs, where an ESOP borrows funds to acquire qualified employer securities, the corporate sponsor makes annual cash contributions to the ESOP to enable it to repay the loan, and effectively receives a tax deduction for both principal and interest payments on the loan. In addition, dividends paid in cash on shares held by an ESOP may be deductible by the sponsoring corporation.
Employees Enjoy Tax Deferred Growth and Special Tax Treatment upon Withdrawal
As with other qualified retirement plans, participants in ESOPs are not required to recognize any taxable income arising out of allocations of employer stock or other contributions to their account in the ESOP, or arising out of appreciation in the value of such stock or the allocation of earnings to their accounts, until their benefits are distributed from the plan. ESOP participants may also receive special tax treatment when their benefits are distributed from an ESOP. For instance, if an ESOP participant receives a lump sum distribution in the form of employer stock (and assuming the participant elects not to rollover or put the stock back to the ESOP or the plan sponsor), income tax on unrealized appreciation (i.e., the value of the stock at the time of distribution in excess of its original cost to the ESOP) is deferred until a subsequent sale of the stock by the participant, at which time the participant gets capital gain treatment.
Potential Benefits for “S” Corporations
“S” corporations may sponsor ESOPs and if an “S” corporations is wholly owned by an ESOP, the corporation avoids tax on the its current income.
Iowa Income Tax Benefits for ESOPs
Iowa law provides for a 50% exclusion of the Iowa net capital gains tax from the sale of an Iowa corporation to an ESOP if the ESOP owns at least 30% of the company after the sale.
What are some additional benefits an ESOP can provide?
In addition to being a qualified retirement plan for employees, an ESOP may also provide:
Improved Employee Performance and Productivity
Many ESOP companies realize increased employee productivity since the employees benefit directly from increases in the profitability of their corporation which boost the value of ESOP stock in their accounts.
Tax Advantaged Corporate Financing
ESOPs can serve as a corporate finance technique.
Business Ownership Succession or Transfer
When a significant owner of a closely held corporation dies or retires, an ESOP may provide a method to insure continuity of management and avoid the need to liquidate the corporation or sell it to “outsiders.”
Hostile Takeover Defense
An ESOP may be available as a mechanism by which a substantial block of shares could be placed in hands of employees who may be more friendly to management than outsiders in the event of a hostile takeover attempt.
Diversification of Investment Portfolios
The stock of a closely held corporation may represent the bulk of the wealth of many business owners. ESOPs, by means of the section 1042 rollover, enable business owners to diversify their investment portfolios on a tax-deferred basis.
Creation of a Market
ESOPs can provide a market for a thinly-traded stock and serve as an alternative to going public.
Gives Back to the Regional Community
In the context of a local or regional small business, utilizing an ESOP can pass-on ownership and the future success of a business to its employees, which can help to prosper the communities where the employees live and work.
Dean R. Einck
Gary J. Streit
Jonathan C. Landon