An Employee Stock Ownership Plan (ESOP) should not be confused with other plans---Employee Stock Purchase Plans (ESSPs), 401k company stock matches, Employee Stock Options (ESOs)---in which employees receive preferential treatment in becoming owners of stock in a company. An ESOP is a qualified, defined contribution plan set up as a trust, in which the company makes annual contributions to individual employee accounts within the trust. ESOPs make the most sense for S corporations and closely held C corporations. The Internal Revenue Service characterizes only one ESOP in its code, but there are three different ways to operate an ESOP within that IRS definition.
Because ESOPs are tax-qualified benefit plans, companies can deduct the cost of their contributions, which is designed to improve cash flow and promote company growth. The company also can deduct any dividends paid to stock held within the trust. Generally, employees receive the vested portion of their accounts only by leaving the company, whether by termination, death, disability or retirement. Distributions may be made either as a lump sum or by a predetermined set of annual installments. Because ESOPs are a tax-qualified benefit plan, the distributions may be rolled over into another tax-deferred plan.
The company can contribute newly issued shares to the trust, or the company can contribute cash to the plan for the sole purpose of buying shares---either from shares held by the corporation or by other stockholders---at a date designated at the time of the contribution. The shares are assigned to the individual employees according to the formula---usually by years of service, proportional compensation or a combination of the two---contained in the agreement creating the trust. A company contributing newly issued shares to the trust can deduct the full market value for the shares, sending the value of the tax savings directly to the bottom line.
In leveraged ESOPs, the company borrows money to finance the contributions to the benefit plan. The company is allowed to deduct not only the principal, but the interest for the loan to buy the stock. This creates a way for companies to receive tax-advantaged loans. In a leveraged-issuance plan, the company essentially pays the proceeds of the loan to itself for the newly issued shares. There are a couple of downsides to the company for a leverage-issuance plan. Newly issued shares dilute the value of the company stock for existing shareholders. Also, the company is creating a future liability when it must repurchase the shares to provide the promised distributions to departing employees. In effect, the company is borrowing from the plan, allowing the contributions to be used as operating capital until shares must be distributed and repurchased for employee benefits.
A leveraged-buyout ESOP allows the company to borrow money to buy shares from existing shareholders, including stock held by the company and stock held by the trust. The debt principal and interest still are paid with pre-tax dollars, but the company can effectively provide departure distributions by buying stock for the trust from the employees who are leaving the company.
C Corporation vs. S Corporation ESOPs
Corporations are designated "C" or "S" depending under which subchapter of the IRS tax code they are taxed. C corporations include most large businesses and many small businesses based on the liability protection such classification affords. S corporations, typically small companies with few shareholders, have elected for their profits to be taxed as an unincorporated business.
C corporations gain most of their tax advantages through deductions for the contributions to the ESOP. S corporations can gain another tax advantage with an ESOP. All taxable income of an S corporation is passed proportionately to the shareholders to be reported on their individual income tax forms. But if S corporations hold all company stock in an ESOP trust, which is tax exempt, the company can turn all taxable income into working capital by avoiding taxes on all its profits.
Taxation of an ESOP
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