An employee stock ownership plan (ESOP) is a type of qualified plan that has important tax consequences for both employers and employees. Whether you're an employer or an employee, knowing how an ESOP offers tax advantages can help you make the best use of this type of retirement plan.
What is an ESOP?
As a qualified plan meeting the requirements of federal tax law and regulations, an ESOP gives employee participants an ownership interest in their employer. The ESOP invests in the employer's stocks. ESOPs benefit employers because they can create and encourage employee motivation, provide a ready market for retiring executives' stock, help solve liquidity problems when a major stockholder dies, and promote objectives such as increasing cash flow and helping to finance another corporation.
Tax Consequences for Employers
Contributions to ESOPs offer employers tax deductions and favorable tax treatment of certain stock-related transactions.
Contributions by the Employer
Employer corporation 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 contribution to an ESOP is limited to 25% of the compensation paid or owed during the tax year to the plan's beneficiaries. In calculating the limit, the maximum compensation of an employee taken into account is $200,000. 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 an additional deduction for "applicable dividends" paid in cash with respect to employer stocks held by an ESOP. An applicable dividend is one that:
- Is paid in cash to plan participants or to their beneficiaries
- Is distributed within 90 after the close of the plan year in which the dividend is paid
- Is paid to the plan and reinvested in qualifying employer securities if the participants make an election to do so
- 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 is limited to $40,000 or 100% of his compensation. Annual additions consist of the employer's contributions, the employee's contributions, and forfeited amounts.
Tax Consequences for Employees
Beneficiaries of ESOP plans are taxed in the year that amounts are distributed or made available to them. When you receive property from an ESOP, such as stock, the amount is usually based on the property's fair market value. Two special rules apply if your distribution includes securities or stock of your employer. First, if the distribution isn't a lump-sum distribution, the amount won't include net unrealized appreciation that are attributable to your contributions to the ESOP. Second, for lump-sum distributions, the amount of distribution is attributable to contributions by the employer.
Taxes on a Distribution of Employer Stock
Here's an example of the taxes on a distribution of employer stock from an ESOP to a plan participant: You receive an ESOP distribution of 10 shares of Class B stock in your employer's corporation. When you sell the stock and calculate your gain, you'll need to know your basis or cost for the stock. Each share has an average cost of $200. Your contributions totaled $120, and your employer contributed $80 (taxed as ordinary income in the year of distribution). The value of each share is now $300.
To figure out the gain on a share of stock, subtract your basis or cost from the value of the share. Your basis is the sum of your and your employer's contributions, and the net unrealized appreciation attributable to your employer's contributions. The net unrealized appreciation on the stock is $100 ($300 current value minus $200). Your employer contributed 40% of the cost of the stock, so 40% or $40 of the net unrealized appreciation counts as part of your basis. This amount is taxable as ordinary income for the year of the distribution. Your basis is $240 - your contribution of $120, $80 from your employer, and $40 of net unrealized appreciation attributable to your employer's contribution.
Different rules apply to lump-sum severance distributions. Internal Revenue Code (IRC) § 402(d)(4)(A) defines a lump-sum distribution as the payment of the balance credited to an employee (participant) due to the employee's death, reaching age 59 1/2, separation from service, or disability.
A 10% penalty tax applies to distributions if the employee is under age 59 ½ . There are exceptions to the penalty tax. Calculating the tax can be complicated. There are tax laws and regulations, such as averaging rules, which lessen the income tax burden. The idea is to treat the distribution as if you received it over several years. The tax for one year is calculated, and then multiplied by the number of years in the averaging period. Your tax advisor or a tax attorney can best help you review the tax liabilities from an ESOP distribution.
Tax-free Rollovers from an ESOP Are Allowed
A tax-free rollover of an "eligible rollover distribution" is allowed under IRC § 402(c)(1). The rollover amount is excluded from your income. The rollover must be made within 60 days of the ESOP distribution. You must transfer the property you receive, less the amount of your contributions, 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, and the averaging election for lump-sum distributions won't apply.
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 trustee-to-trustee transfer between the ESOP and the rollover vehicle. The ESOP administrator should give you advance written notice of your rollover options.
Questions for Your Attorney
- As a business owner, I'm considering starting an ESOP. Can you help me assess the tax implications for my situation?
- I'm an employee-participant in an ESOP, and I've changed jobs. I want to rollover my account assets to another retirement plan, but which one? Should I choose an IRA or a plan offered by my new employer?
- What are the tax planning issues my company should consider when deciding on the ESOP contributions for this year?
Related Resources on Lawyers.comsm
- <"http: finance.lawyers.com/personal-finance-and-credit-forms.html"="">Personal Finance and Credit Forms
- Major Advantages and Disadvantages of ESOPs
- <"http: taxation.lawyers.com/tax-planning/"="">Taxation articles and information
- Find a Taxation Law lawyer in your area
- Visit the Business Tax message boards for more help
- Visit the Personal Tax Message boards for more help