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ESOP Tax Incentives

What are the ESOP Tax Incentives?

Owners who sell stock to an ESOP will pay tax at the 15% long-term capital gains tax rate (worst case scenario).  If the Company is a C corporation, the seller(s) may be able to defer tax, perhaps even permanently. Employees participating in the ESOPs are not taxed on the stock allocated to their accounts or on its earning until distributed generally at death, disability, retirement or termination of service (subject to vesting). Companies that sponsor ESOPs are able to deduct ESOP contributions (subject to certain limitations).  This results in a Company converting what would have been a non-tax deductible principal payment on a loan into a tax deductible retirement plan contribution.  This tax benefit is available for C and S corporations.

C Corporations also are able to deduct dividends paid on ESOP held stock under certain conditions.  This is the only way a company can get a tax deduction for dividend payments and it may allow a company an avenue to get money into its ESOP in excess of the contribution limits referenced above.

S corporations are “flow-through” entities for tax purposes, which means that they do not pay tax.  Instead, their income “flows through” to their owners who include their share of the company’s taxable income and on their tax return.  Let’s follow a corporation through the process.

  • Assume an S corporation has $5 million of taxable income and 2 equal shareholders; each of them would receive an IRS form K-1 for $2.5 million.
  • Assuming that they pay tax at the 35% federal tax rate, each of them would pay $875,000 in federal income tax on the S corporation earnings.
  • However, since an ESOT, like all qualified retirement plan trusts is tax exempt, its portion of the Company’s income is free from taxation.
  • Therefore, in the example above, if an ESOP were one of the two owners, the tax liability on the Company’s income would be reduced in half, saving $875,000.
  • If an ESOP owned all of the Company in this example, the Company’s $5 million of taxable income would be completely free from federal income tax, saving $1.75 million in income taxes.

As can be seen, Congress has created powerful tax incentives for business owners to use ESOP as an ownership succession planning vehicle and in so doing, share the wealth with their employees.

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