How The ESOP Works and Benefits

Benefits Of The ESOP To C Corporations

Benefits Of The ESOP To S Corporations

What is an ESOP?

An Employee Stock Ownership Plan (ESOP) is an IRS qualified benefit (defined contribution) plan designed to invest primarily in employer stock.

To establish an ESOP a company sets up a trust to hold the assets and makes contributions to it of company stock or cash. Each employee participates by receiving a contribution based on his or her earnings. The employee receives a contribution without him or her making any cash outlay, any reduction in pay or losing any other employee benefits.

When the company makes cash contributions to the ESOP, the company or a shareholder can sell his or her stock to the ESOP and receive the cash.

When a shareholder of a C Corporation sells his or her stock to an ESOP, the transaction can be designed so that the shareholder defers capital gains tax on the cash received from the sale. The financial benefit of this tax deferred (possibly tax free) sale is that the selling shareholder will retain 15% - 25% more gain.

How does an ESOP work?

The contributions a company makes to an ESOP are tax deductible up to 25% of the payroll of the participants in the plan. The ESOP also can borrow funds to buy new or existing shares of company stock, when it does borrow money, the tax reduction benefits increase (for both C & S Corporations).

For C corporations tax deductible contributions of up to 25% of payroll may be used to repay the principal on the ESOP loan, plus interest payments can be paid with no payroll percentage limitations. Also, reasonable dividends from company stock used to repay debt have no payroll percentage limitations and are usually tax deductible.

For S corporations, in addition to the 25% of payroll maximum deductions, the company is not taxed on S corporations earnings that are attributed to ESOP stock. The higher percentage of stock owned by an ESOP in an S corporation the less S corporation taxes are owed. For a 100% S corporation ESOP the company could be tax exempt!

Through an ESOP, a corporation can use tax deductible dollars for making company improvements, corporate expansion or using capital for other needs. When tied to an ESOP, corporate debt payments of both principal and interest are tax deductible.