A disadvantage of ESOPs (or any other qualified retirement plan) is that even if the Roth benefits of an ESOP have been maximized, younger employees still have to wait until age 59 1/2 to access the funds for consumption. If they receive their ESOP benefits before age 59 1/2 and don't roll them over to an IRA or another qualified retirement plan, they incur extra 10% federal and 2.5% (in California) early distribution penalties.
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.
For those who cannot wait, we can design an ESOP with Synthetic Equity which provides benefits before 59 1/2, and although that's too early for the benefits to be Roth benefits, they can be treated as long-term capital gains. With the combination of an ESOP with Synthetic Equity, with proper planning, benefits which most would expect to be taxed as ordinary income can be treated as long-term capital gain. With an additional layer of complexity, the benefits can be treated as §1202 qualified small business stock excluded gain. §409(p) Safe Harbor provisions should be included in Synthetic Equity plans and the grants of Synthetic Equity interests thereunder.
Success Story
A start up ESOP/S Corporation was established in 2017 by founders who were all Gen Z (all were under 25 at the time). They really appreciated the tax-free feature of the ESOP/S Corporation structure, which was very helpful in accumulating working capital for the business, and they allowed all employees to make their share of the ESOP Loan payments with Roth Salary Deferrals so that their respective shares of allocated employer stock would be allocated to their Roth employer stock accounts under the plan. What the founders did not appreciate was that they would have to wait until age 59 1/2 to get these great tax-free benefits.
The solution? In 2023, the S Corporation transferred its operating business down into an LLC, and then granted profit membership interests to select employees, which profits membership interests would be triggered upon a "monetizing event," such as a sale of the corporation or its operating business assets. Each employee filed an 83(b) election so that upon the monetizing event they would anticipate having capital gain treatment, but most importantly without having to wait until age 59 1/2. This would not be as good a result as Roth tax-free treatment, but capital gain treatment well before age 59 1/2 for a portion of the enterprise value was accomplished. The young generation was appeased.
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