ESOP Tax Incentives and Contribution Limits
Congress has enacted tax incentives for employee stock ownership plans (ESOPs) that provide advantages for not only the sponsoring company but also the employees, the lender to an ESOP, and selling shareholders in closely held companies. Many states have laws that automatically track these provisions, thus magnifying the tax incentives.
Deductibility of ESOP Contributions
Employer contributions to the ESOP generally are tax-deductible up to a limit of 25% of covered payroll (this limit also includes employer contributions to other defined contribution plans). For a C corporation with a leveraged ESOP, the 25% limit does not include contributions to pay interest on the loan. The law appears to allow a C corporation to also contribute up to an additional 25% that is not used for payments on an ESOP loan (discussed below).
The contribution and deduction limits for an S corporation ESOP are the same as for a nonleveraged C corporation ESOP. However, even if the S corporation ESOP is leveraged, the company is not entitled to exclude the loan's interest expense from the 25% limit.
The 2017 bill limits net interest deductions for businesses to 30% of EBITDA (earnings before interest, taxes, depreciation, and amortization) for four years, at which point the limit decreases to 30% of EBIT (not EBITDA). In other words, starting in 2022, businesses will subtract depreciation and amortization from their earnings before calculating their maximum deductible interest payments.
New leveraged ESOPs where the company borrows an amount that is large relative to its EBITDA may find that their deductible expenses will be lower and, therefore, their taxable income may be higher under this change. This change will not affect 100%-ESOP owned S corporations because they don't pay tax.
Deductibility of Dividends Paid on ESOP-Held Stock
Companies that sponsor ESOPs can deduct dividends paid on ESOP-held stock primarily in three ways. First, dividends may be paid in cash to ESOP participants, either directly or as payments to the ESOP that are distributed to participants within 90 days after the close of the plan year. Second, dividends may be applied to a leveraged ESOP's loan payments (but only dividends on the shares bought with the loan can be used to make such payments). Third, dividends voluntarily reinvested in company stock in the ESOP by employees are deductible to the company.
Dividend deductions are not subject to the 25% limits described above for ESOP contributions. To be deductible, dividends must be "reasonable."
S corporation distributions (the equivalent of dividends) are not tax-deductible, but they can be used to repay an ESOP loan.
Deferring Taxation Using the Section 1042 "Rollover"
Providing for business continuity is one of the most difficult challenges for closely held companies. Even if buyers can be found, the terms of their offers may not be acceptable, either financially or personally. For example, a buyer may want to shut down the company or eliminate valued employees. As hard as it is to sell a business outright, it is even harder to sell it in stages, allowing for a gradual withdrawal by the owner; or partially, allowing heirs, key managers, or others to have a partial ownership interest.
An ESOP provides a way to accomplish these goals in a tax-advantaged manner and to manage the sale process more effectively. First, as described above, the ESOP allows the company to use pretax dollars to buy out the owners. This can be done under whatever schedule is practical. Second, the seller(s) can defer capital gains taxation on the sale proceeds.
Under section 1042 of the Internal Revenue Code (the "Code"), an owner of a closely held C corporation (but not an S corporation) can defer capital gains taxation on stock he or she sells to an ESOP if (1) the ESOP owns 30% or more of each class of outstanding stock or of the total value of all outstanding stock, excluding nonconvertible, nonvoting preferred stock; and (2) the seller reinvests ("rolls over") the sale proceeds into qualified replacement property (stocks or bonds of domestic operating companies) during the period from three months before to twelve months after the sale. As explained below, the price an ESOP pays in such transactions is based on a valuation by a qualified, independent appraiser.
The money "rolled over" into replacement property need not be the actual proceeds from the sale, but rather can be an equivalent amount of money from another source. Any or all of the proceeds can be rolled over; the seller(s) will simply pay taxes on the rest. Two or more owners may combine their sales to meet the 30% requirement if the sales are part of a single, integrated transaction. It has become increasingly common in section 1042 transactions for sellers to facilitate the sale by pledging part or all of their replacement property as collateral for the loan, especially in companies with limited assets or with substantial debt.
None of the shares sold to the ESOP in a transaction to which section 1042 applies may be allocated to ESOP accounts of the seller, certain relatives of the seller (ancestors, siblings, the spouse, or lineal descendants), non-selling shareholders holding more than 25% of company stock, or family members of the more-than-25% shareholders if they own stock by attribution (e.g., spouses). (This restriction does not apply to ESOP stock not purchased in the rollover transaction.) There is one exception: lineal descendants of the selling shareholder(s) may be allocated a total of 5% of the stock, provided that the lineal descendants are not treated as more-than-25% shareholders by attribution.
There are other requirements for the section 1042 rollover; for example, the selling shareholder(s) must have held the stock for at least three years before the sale and cannot have received the stock through exercising stock options or certain employee stock arrangements under section 83 of the Code. If the ESOP disposes of the shares within three years after the sale, the employer generally must pay a 10% excise tax on the proceeds from the disposition.
Sellers using the section 1042 rollover often avoid taxation completely by retaining the replacement property until death, at which time the property transfers to their heirs with a stepped-up basis.
S Corporation Benefits
Since January 1, 1998, S corporations have been able to have ESOPs as owners. These ESOPs do not qualify the seller for section 1042 treatment, do not allow for the deductibility of dividends, and must count interest payments on an ESOP loan toward contribution limits. Forfeitures of unvested shares count toward the limits on how much can be added annually to a participant's account (they do not in C corporation ESOPs, provided that not more than one-third of the ESOP benefits go to highly compensated employees). On the other hand, the ESOP is not taxable on its share of corporate earnings.
Tax Treatment of ESOP Benefits
Employees pay no tax on stock allocated to their ESOP accounts until they receive distributions; at that point, they are taxed on the distributions. If they are younger than age 59 1/2 (or age 55 if they have terminated employment), they, like employees in qualified plans generally, are subject not only to applicable taxes but also to an additional 10% excise tax unless they roll the money over into an IRA or a successor plan in another company (or unless the participant terminated employment due to death or disability). Certain lump-sum distributions from an ESOP may be eligible for favorable income averaging and/or capital gains tax treatment.
If the money is rolled over into a traditional IRA or a successor plan, the employee pays no tax until the money is withdrawn, at which point it is taxed as ordinary income. Rollovers from ESOP distributions to IRAs are available for distributions of stock or cash over periods of less than 10 years. (Amounts rolled over into a Roth IRA are taxable, although the 10% early distribution excise tax mentioned above does not apply.)
When dividends are directly paid to plan participants on the stock allocated to their ESOP accounts, such dividends are fully taxable, although they are exempt from income tax withholding and are not subject to the excise tax that applies to early distributions.
Company Contribution Limits
In general, companies can deduct up to 25% of eligible pay to defined contribution plans (ESOPs, 401(k), profit sharing, money purchase, and stock bonus plans). This is a combined limit that aggregates contributions to all these plans. However, recent (2004 onward) private letter rulings from the IRS indicate that in a C corporation with a leveraged ESOP, there are separate 25% limits for (1) employer contributions to repay the principal on an ESOP loan and (2) employer contributions to other defined contribution plans or to a nonleveraged component of the ESOP itself (i.e., payments to the ESOP that are not used to pay either principal or interest on an ESOP loan). Thus, a C corporation with a leveraged ESOP has a total 50% contribution limit available to it.
Eligible pay is defined as the pay of all the participants in the plan up to $275,000 in 2018 dollars (this is indexed for inflation, rounded to $5,000 increments). Employee deferrals into 401(k) plans or cafeteria plans no longer reduce the eligible pay against which this 25% is computed. In C corporations, the interest on payments on an ESOP loan does not count towards the 25% limit; in S corporations, it does.
Limits on Annual Additions to Employee Accounts
The combination of employer contributions and employee deferrals into defined contribution plans (ESOPs, 401(k) plans, etc.) cannot exceed 100% of of any plan participant's eligible pay in any one year. This limit is constrained, however, by a second limit, which provided that not more than $55,000 can be added (as of 2018; this is indexed for inflation).
Special Rules for Leveraged ESOPs
Reasonable dividends paid on ESOP shares can be used to pay off an ESOP loan. In a C corporation, but not an S corporation, these dividends do not count toward the contribution limits. In S corporations, however, company distributions (which are not technically dividends and are not tax-deductible) do not count as contributions and are not covered by the 25% of pay limit. These S corporation distributions, when made to either allocated or unallocated shares, can be used to repay an ESOP loan without limit.
S Corporation Issues
Special rules for S corporations are incorporated in the text above, but can be simply reiterated here. The limit on tax-deductible employer contributions is 25% of pay, whether the ESOP is leveraged or not. Contributions to 401(k), profit sharing, money purchase, and stock bonus plans count towards this limit, as do interest payments on an ESOP loan. Distributions on shares in the ESOP, for whatever purpose they are used, do not count as contributions. Annual addition rules for plan participants are the same as in C corporations.
How Much Is Enough?
Employers often ask not "how much can we contribute," but "how much should we contribute to make plans meaningful to employees." The average corporate contribution to all retirement-oriented plans combined is only about 4% of pay (this does not count employee contributions). The average ESOP contribution, according to various surveys, is about 6%-10% of pay. More than 80% of all ESOP participants also are in another company-sponsored plan, often a 401(k) plan. How much is enough to make employees fell like owners, unfortunately, cannot be answered, but research does show the higher the contribution, the more employees feel like owners.
Whether calculating legal limits or practical guidelines, it is important to get qualified, ongoing advice. The penalties for violating the limits are both severe and, with planning, easily avoided.