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How ESOPs, Profit Sharing Plans, and Stock Bonus Plans Differ as Employee Ownership Vehicles

Corey Rosen

ESOPs, profit sharing plans, and stock bonus plans are all governed by the Employee Retirement Income Security Act. They all have the same rules for eligibility, allocation of benefits, and vesting. Contributions to all the plans are tax-deductible. There are some significant differences, however. ESOPs have substantial additional tax benefits beyond the deductibility of contributions, most notably the ability of sellers to certain ESOPs to defer capital gains taxes, the deductibility of dividends paid on ESOP shares, the ability to use dividends or (in S corporations) distributions of earnings to increase the allowable contribution limits, and, in S corporations, not paying income tax on that proportion of ownership attributable to the ESOP. Also, only ESOPs can borrow money on the credit of the company to buy employer stock. Stock bonus and profit sharing plans have somewhat less restrictive rules than ESOPs, however, particularly around distribution requirements, valuation requirements, and what percentage of assets must be held in company stock.

In general, companies not needing to borrow money through the plan, not using the plan to provide the seller the special tax deferral treatment available to sellers to C corporation ESOPs, and/or not wanting to be an S corporation to obtain the special S corporation ESOP tax benefits may find there are no special benefits to having a statutory ESOP.

The table below summarizes the key differences between these plans.
Key Tax Benefits
 ESOPsProfit SharingStock Bonus Plans
Deductibility of employer contributions to the planDeductible up to 25% of eligible compensation. In C corporations, contributions made to pay interest on an ESOP loan generally do not count toward this limit.Deductible up to 25% of eligible compensation (profit sharing plans cannot borrow money from the company or using its credit to buy company stock, so the interest exclusion does not apply).Deductible up to 25% of eligible compensation (profit sharing plans cannot borrow money from the company or using its credit to buy company stock, so the interest exclusion does not apply).
Deductibility of dividendsDividends are deductible if used to repay an ESOP loan, are passed through to participants, or are voluntarily reinvested in company stock by employees.Dividends paid on shares are not deductible.Dividends paid on shares are not deductible.
Tax benefits to ownersSeller can defer taxation of gains from a sale to an ESOP in a C corporation that owns at least 30% of company stock after the sale.No tax benefits to sellers to the plan trust.No tax benefits to sellers to the plan trust.
Taxation of ownership by plan in S corporationAllocation of corporate income to the ESOP based on ESOP ownership is not subject to current taxation on the ESOP.Plan trusts must pay unrelated business income tax on their attributed corporate income based on ownership. Plan trusts must pay unrelated business income tax on their attributed corporate income based on ownership.
Employee taxationTaxed in the same way as other defined contribution plans based on distributions from the plan not otherwise rolled over to another qualified plan or an IRA.Taxed in the same way as other defined contribution plans based on distributions from the plan not otherwise rolled over to another qualified plan or an IRA.Taxed in the same way as other defined contribution plans based on distributions from the plan not otherwise rolled over to another qualified plan or an IRA.
Rules
 ESOPsProfit SharingStock Bonus Plans
Borrowing moneyCan borrow money from the company or using its credit to buy employer stock.Cannot borrow money from the company or using its credit to buy employer stock.Cannot borrow money from the company or using its credit to buy employer stock.
GovernanceTrust is governed by a plan trustee who must operate the plan for the exclusive benefit of plan participants.Trust is governed by a plan trustee who must operate the plan for the exclusive benefit of plan participants.Trust is governed by a plan trustee who must operate the plan for the exclusive benefit of plan participants.
VotingPlan participants must be able to direct the trustee as to the voting of the shares on a limited number of issues, most significantly the sale of all or substantially all the assets of the employer.No voting requirements.Same voting requirements as for ESOPs if more than 10% of plan assets are in company stock; otherwise no voting requirements.
Distribution timingGenerally, must offer distribution commencing within six years after end of plan year for termination unless termination is for death, disability or retirement, in which case distribution must begin not later than one year after the end of the plan year after termination.Must begin by normal retirement age but it is rare for plans to wait that long.Generally, must offer distribution commencing within six years after end of plan year for termination unless termination is for death, disability or retirement, in which case distribution must begin not later than one year after the end of the plan year after
Form of distributionEmployee must have the right to demand distributions in the form of company stock unless company is an S corporation or has bylaws requiring that all or substantially all the shares be held by employees.Can be in stock or cash.Employee must have the right to demand distributions in the form of company stock unless company is an S corporation or has bylaws requiring that all or substantially all the shares be held by employees.
Eligibility and vesting rulesRules are generally the same as for other defined contribution plans.Rules are generally the same as for other defined contribution plans.Rules are generally the same as for other defined contribution plans.
AllocationGenerally must allocate based on relative compensation or a more level formula; permitted disparity (integration with Social Security) and cross-testing (age weighting or comparability testing based on projected future benefits) not allowed.In addition to allocation rules that apply to ESOPs, companies can use permitted disparity (integration with Social Security) and cross-testing (age weighting or comparability testing based on projected future benefits).In addition to allocation rules that apply to ESOPs, companies can use permitted disparity (integration with Social Security) and cross-testing (age weighting or comparability testing based on projected future benefits).
Put optionEmployees must have a put option on shares distributed to them.Not applicableEmployees must have a put option on shares distributed to them.
Required investment in company stockPlan must be primarily invested in company stock with the highest combination of voting and dividend rights.No minimum requirement; plan can hold any class of shares.No minimum requirement; plan can hold any class of shares.
ValuationRequired annually by statute.Not required by statute, but strongly advised for fiduciary protectionNot required by statute, but strongly advised for fiduciary protection
Fiduciary ConcernsSubject to close scrutiny by DOL with respect to valuation and prohibited transaction rules.Subject to close scrutiny by DOL with respect to valuation and prohibited transaction rules; also subject to scrutiny relative to prudence and diversification.Subject to close scrutiny by DOL with respect to valuation and prohibited transaction rules.
Diversification out of company stockPrivate companies, and standalone ESOPs in public companies: Participants aged 55 and with 10 years in the plan must be allowed to diversify a total of 50% of company stock over six years.
Public company ESOPs combined with a 401(k) plan:* All participants have can diversify out of all company stock, except that a precondition of three years of service can be imposed on diversifying out of company stock from employer contributions.**
Private companies: No diversification requirement.
Public companies:* All participants have can diversify out of all company stock, except that a precondition of three years of service can be imposed on diversifying out of company stock from employer contributions.**
Private companies: No diversification requirement.
Public companies:* All participants have can diversify out of all company stock, except that a precondition of three years of service can be imposed on diversifying out of company stock from employer contributions.**
*One-participant plans are excepted from this requirement.
**The three-year requirement does not apply to beneficiaries of deceased participants.

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