Major Tax Benefits of ESOP
Some of the important tax benefits of ESOP are given below:
1- Contributions of Stock are Tax-Deductible
That means companies can get a current cash flow advantage by issuing new shares or treasury shares to the ESOP, albeit this means existing owners will be diluted.
2- Cash Contributions are Deductible
A company can contribute cash on a discretionary basis year-to-year and take a tax deduction for it, whether the contribution is used to buy shares from current owners or to build up a cash reserve in the Employee Stock Ownership Plan for future use.
3- Contributions used to repay a loan the ESOP takes out to buy company shares are Tax-Deductible
The ESOP can borrow money to buy existing shares, new shares, or treasury shares. Regardless of the use, the contributions are deductible, meaning ESOP financing is done in pretax dollars.
4- Sellers in a C corporation can get a tax deferral
In C corporations, once the ESOP owns 30% of all the shares in the company, the seller can reinvest the proceeds of the sale in other securities and defer any tax on the gain.
5- No Income Tax benefit on profits of an S Corporation
That means, for instance, that there is no income tax on 30% of the profits of an S corporation with an ESOP holding 30% of the stock, and no income tax at all on the profits of an S corporation wholly owned by its ESOP. Note, however, that the ESOP still must get a pro-rata share of any distributions the company makes to owners.
6- Dividends are Tax-Deductible
Reasonable dividends used to repay an ESOP loan passed through to employees, or reinvested by employees in company stock are tax-deductible.
7- Employees pay no tax on the contributions to the ESOP
The employees can roll over their distributions in an IRA or other retirement plan or pay current tax on the distribution, with any gains accumulated over time taxed as capital gains. The income tax portion of the distributions, however, is subject to a 10% penalty if made before normal retirement age.
Tax Consequences of ESOP for Employer
Contributions to ESOPs offer employers tax deductions and favorable tax treatment of certain stock-related transactions.
Contributions by the Employer
Employer contributions to an ESOP are deductible in the year they are actually made to the plan. The contribution can consist of cash or the employer corporation’s stock. If a contribution is made in stock, the employer won’t recognize any gain or loss on its taxes.
An employer’s tax-deductible contribution to an ESOP is limited to 25% of the compensation paid or owed during the tax year to all of the plan’s beneficiaries, with a certain maximum compensation of an employee taken into account (this limit increases most years). If the contribution is more than the limit for a given year, the excess amount can be carried forward to future tax years.
Dividends on Employer Stocks
Additional deductions are allowed to employers for dividends paid on the employer’s stocks that are held by a plan. A C corporation is allowed a deduction for “applicable dividends” paid in cash. An applicable dividend is one that:
1- Is paid in cash directly to plan participants or to their beneficiaries, or
2- Is paid to the ESOP and is distributed within 90 after the close of the plan year in which the dividend is paid, or
3- Is paid to the plan and reinvested in qualifying employer securities (if the participants are given the choice between having the dividends reinvested or receiving them in cash), or
4- Is used to make payments on a loan that was used to buy the stock that generated the dividend.
Additional regulations apply to deductions for dividends on employer stock.
Deductions and Leveraged ESOPs
The deduction is unlimited if an employer’s ESOP contributions are used to pay interest on a loan of a leveraged ESOP. A leveraged ESOP is one that borrowed funds to buy qualifying employer stock. The deduction is allowed if the interest was on a loan used to buy the employer’s stock.
Limits on Annual Additions
Under Internal Revenue Code (IRC) § 415(c)(1), the annual addition to a plan participant (consisting of the employer’s contributions, the employee’s contributions, and forfeited amounts) is limited to $54,000 or 100% of the participant’s compensation, whichever is less.
Tax Consequences of ESOP for Employee
Beneficiaries of ESOP plans are taxed in the year that amounts are distributed or made available to them.
Taxes on a Distribution of Employer Stock
ESOP distributions can be made in a lump sum or in substantially equal payments (annually or more frequently). Installment payments must be made within five years or less.
Distributions are taxed as ordinary income, but if you receive a lump-sum distribution in the form of stock, you’ll generally pay ordinary income tax on the value of your employer’s contributions to the plan, and capital gains tax on the appreciation in stock value when the stock is sold. (In other words, the taxable amount is the difference between the property’s fair market value and your cost basis in the property.)
If you receive a distribution from an ESOP before you are age 59 ½, the distribution will be subject to a 10% early distribution penalty tax (unless the distribution is due to a disability, medical expenses, child support, or a few other exceptions).
Taxes on Dividends Paid to Employees
There is no 10% early distribution tax on distributions that are dividends from an ESOP, even if you receive them before age 59 ½.
Tax-Free Rollovers From an ESOP Are Allowed
A tax-free rollover of an “eligible rollover distribution” from an ESOP is allowed under IRC § 402(c)(1). Amounts rolled over from an ESOP are not taxed as your income, if the rollover is made within 60 days of the ESOP distribution. You can transfer the distribution to an individual retirement account (IRA), an individual retirement annuity, or to another employer’s qualified retirement plan. Amounts you receive from an IRA or annuity are then taxed as ordinary income.
Post-1992 eligible rollovers are subject to a 20% withholding tax, even if it’s completed within the allowed 60-day time period. You can avoid withholding with a direct transfer between the ESOP and the rollover IRA or annuity. The ESOP administrator should give you advance written notice of your rollover options.