Tax Advantages

ESOPs carry tax advantages that just aren’t there with other types of business transitions. There are benefits for both the selling shareholders and the company itself.

A selling shareholder can elect to defer any capital gain that he or she would realize upon the sale of stock to the ESOP, as long as the company is taxed as a C corporation at the time of the sale. This is referred to as a “1042 election” in reference to the section of the tax code that authorizes the deferral of the gain. In order for this to be available, the ESOP has to own at least 30% of the company after the sale (which is why many ESOPs start at 30% ownership) and the owner has to reinvest the proceeds in “qualified replacement property” such as domestic stocks and bonds. The owner doesn’t pay capital gains tax until the qualified replacement property is sold. It’s also possible for the selling shareholder to borrow against the qualified replacement property in order to get some liquidity while still preserving the deferral of the capital gains.

For the company, tax advantages come from the fact that the ESOP is a qualified retirement plan. The company makes contributions to the ESOP to help fund the purchase of the shares from the owner. Those contributions, just like employer contributions to a 401(k) plan, are tax-deductible for the company. But that isn’t even the best part….

Because the ESOP is a tax-qualified retirement plan, it’s a tax-exempt entity. An ESOP can own an S corporation, which (with some exceptions) doesn’t pay tax on the income it earns – instead, the corporation passes the income up to its shareholders, who pay tax on the income. Well, if the income gets passed up to a tax-exempt entity, that income isn’t taxed at all! This means that if an ESOP owns 100% of an S corporation, none of that company’s income is subject to federal income taxes. That’s a significant cash savings that the company can use for things like expansion, capital investments and other things that can help the business.