Employee Stock Ownership Plans (ESOPs)

ESOP Planning: A Few Practical Things to Know About ESOPs

An ESOP which owns a C Corporation can manage its taxable income with contributions to the ESOP, contributions to a Defined Benefit Pension Plan (DBPP) and deductible dividends on common or convertible preferred stock.

You can sell the stock of your Corporation to an ESOP. If your Corporation is a C Corporation, any gain on the sale can be deferred under §1042 by investing in a "qualified replacement property" corporation, including a closely held corporation (similar to what you can do for real estate with a §1031 exchange), or if your Corporation is a "qualified small business", the gain can be excluded under the §1202 qualified small business stock exclusion.

You can sell the stock of your Corporation to an ESOP for a long-term installment sale/promissory note, and with proper planning, still qualify for the §1042 deferral.

If your Corporation is an S Corporation, the gain on an installment sale can be deferred under the installment sale rules, with an opportunity zone investment under §1400Z-2, or other tax planning strategies.

An ESOP/S CORP can be beneficial for a start-up where the ESOP subscribes to the initial capital stock with a long-term promissory note (an "ESOP Loan"). We have helped numerous clients in doing so. You can also reorganize to spin off a profit center of an existing business to a new ESOP/S Corp to accomplish similar results.

Employees share in the allocation of stock as the ESOP Loan for the installment sale or subscription for stock is paid. A 25-year ESOP Loan would result in 4% of the stock being allocated each year. A 50-year ESOP Loan would result in a 2% of the stock being allocated each year. The unallocated unpaid for stock is not owned by any participant, but is held by the ESOP in suspense to be allocated to the participants in the future over the remaining term of the ESOP Loan.

An ESOP can include a §401(k) component with a Designated Roth Contribution Program, with tax-free results. Imagine paying your ESOP loan with Roth Salary Deferrals!

An ESOP is ideal for a start-up which anticipates a monetizing event after a few years.

An ESOP with properly structured synthetic equity can result in capital gain for the synthetic equity component. Synthetic equity can be monetized, paid to the Participant, taxed as capital gain, and not be subject to any 10% early distribution penalties. Some view synthetic equity as better than a qualified retirement plan since it can have lower tax rates, you don't have to wait until age 59 1/2, and is not subject to the 10% early distribution penalty, even though it cannot be rolled over to an IRA or another qualified plan. If the synthetic equity is structured through a complementing C Corporation, the §1202 qualified small business stock exclusion could apply. See Synthetic Equity Planning.

Just because a corporation which sponsors and is owned by an ESOP sells or monetizes its initial operating business does not mean that the ESOP has to be terminated. Instead, the ESOP can continue in tax-exempt form for years thereafter for the benefit of the founders and other remaining employees. We can show you the advantages of doing so.