ESOP Tax Benefits: Who Gains and How?
Explore how an ESOP's tax structure creates aligned benefits, from the initial ownership transfer to corporate cash flow and employee wealth-building.
An Employee Stock Ownership Plan (ESOP) is a specific type of employee benefit plan that functions as a trust. This trust is created to purchase, hold, and distribute company stock to employees over time. This structure provides a way for business owners to sell their stake in the company while offering employees an ownership interest. Governed by federal retirement plan rules, an ESOP’s unique design creates a range of tax incentives for the selling business owner, the company, and participating employees.
Tax Advantages for the Selling Shareholder
A significant tax incentive for a business owner selling to an ESOP is the ability to defer capital gains tax, as detailed in Internal Revenue Code Section 1042. This provision allows a seller to postpone the capital gains tax that would be due from the sale of a highly appreciated asset. This deferral can increase the net proceeds a seller receives compared to a conventional sale.
To qualify for this tax deferral, the full benefit is limited to sales of C corporation stock, though a partial deferral is available for S corporations. For sales after December 31, 2027, S corporation shareholders may defer up to 10% of their capital gains. Following the transaction, the ESOP must own at least 30% of the company’s stock, and the seller must have held the stock for at least three years prior to the sale.
The deferral is achieved by reinvesting the sale proceeds into Qualified Replacement Property (QRP). This reinvestment must occur within a 15-month window, which begins three months before the sale and ends 12 months after. Failure to adhere to these rules can result in the disqualification of the tax deferral and an immediate tax liability.
QRP consists of stocks and bonds from domestic operating companies. Mutual funds and U.S. Treasury bonds are not considered eligible QRP investments. The tax on the original sale is deferred until the QRP is eventually sold. If the seller holds the QRP until death, the assets receive a “step-up” in basis, allowing the seller’s heirs to sell the QRP without triggering the deferred capital gains tax.
Tax Advantages for the Sponsoring Company
The corporation that establishes an ESOP gains access to tax deductions. The company can make tax-deductible contributions to the plan, either in cash or by contributing company stock directly. These contributions are limited to 25% of the company’s eligible employee payroll.
In a leveraged ESOP, the plan borrows funds to purchase company stock, and the company makes annual tax-deductible contributions to repay the loan. For a C corporation, contributions for loan principal are deductible up to 25% of payroll, while interest payments are fully deductible. For S corporations, both principal and interest payments are combined under the 25% of payroll deduction limit.
The tax advantages are more pronounced for S corporations, which are pass-through entities where profits are passed to shareholders who then pay income tax. When an ESOP owns stock in an S corporation, the portion of the company’s income attributable to the ESOP’s ownership is exempt from federal income tax because the ESOP is a tax-exempt trust.
For an S corporation that is 100% owned by its ESOP, the company can become entirely exempt from federal income taxes. This tax-free status can generate cash flow savings that can be retained to fund growth, pay down debt, or increase working capital.
Tax Advantages for Employee Participants
Employees who participate in an ESOP receive their ownership stake without any out-of-pocket investment. The stock allocated to their accounts grows on a tax-deferred basis, meaning the employee does not owe tax on that appreciation while the shares remain in their account. This allows the value of their retirement benefit to compound without being diminished by annual taxes.
When an employee retires or separates from the company, they receive a distribution from their ESOP account, which is taxed as ordinary income. Employees can manage this tax event by choosing to roll over their distribution into a traditional IRA or another qualified retirement plan. This continues the tax deferral until they take withdrawals from that new account.
A tax rule known as Net Unrealized Appreciation (NUA) offers a benefit for employees who receive a lump-sum distribution of company stock. Under NUA rules, the employee pays ordinary income tax only on the original cost basis of the stock. The remaining value, the appreciation, is not taxed until the employee sells the shares, at which point it is taxed at long-term capital gains rates.
To qualify for NUA treatment, the distribution must be a lump-sum payment of the employee’s entire account balance within one calendar year, following a triggering event like reaching age 59½ or separation from service. The shares must be distributed “in-kind,” meaning the employee receives the actual stock. This option is not available to participants in S corporations that are 100% owned by an ESOP, as these companies pay departing employees in cash.