Frequently Asked Questions

Employee Ownership FAQs

Common questions about employee stock ownership plans (ESOPs), employee ownership trusts (EOTs), and other forms of employee ownership, from the basics to technical topics.

This FAQ is written primarily for business owners, managers, and advisors involved in setting up or running an employee ownership plan. If you're an employee at an ESOP company looking to understand your own benefits and rights, see our articles on Working at an ESOP Company and The Rights of ESOP Participants.

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Why would a company choose to stay Subchapter S rather than convert to a C corporation when buying out an owner?

C corporations pay tax on earnings--if any of those earnings are distributed as dividends, a second round of tax is paid by the owners. Any retained earnings are, in effect, ultimately taxed again to owners as additional capital gains as reflected in an increased share price when the stock is sold.

Subchapter S status allows a company not to pay tax at the corporate level. Instead, all earnings are allocated to owners, who pay tax on them at personal tax rates, whether they actually receive these earnings or not. Since the ESOP itself is a tax-exempt entity, to the extent the ESOP owns an S corporation, neither the corporation nor the owners pay taxes.

However, where an ESOP is used to buy out an owner, the tax advantages of an S corporation may be less significant, at least early on. The ESOP contributions normally would reduce the corporate tax rate to a very low level, making the ESOP S corporation tax shield less valuable. In addition, the seller can only take advantage of the "rollover" deferral on ESOP gains in a C corporation.

The advantage of S corporation ESOPs are most compelling in the following five situations:

1. The seller is not the only owner. While the seller benefits from the conversion to C status, the other owners now find any of their earnings that would have been sheltered from the corporate level tax no longer are. If the sale does not create enough deductions to reduce the corporate level tax low enough to satisfy these owners, they may not want to convert. Note, however, that the other owners may not face this problem if the ESOP creates enough debt or contribution obligations to reduce or eliminate the corporate level tax.

2. There are large amounts of undistributed earnings. When the conversion to a C corporation takes place, any earnings that have not yet been contributed to the owners must be distributed in one year or they are taxable to the owners (meaning they will be taxed twice, since the owners have already paid tax on them before). If the company does not have the cash to do this, it could borrow money, but the ESOP may itself require too much cash to make this payout practical.

3. Remaining owners plan to sell the company in an asset sale some time after the ESOP is implemented. In an S corporation, the sale of the company's assets trigger only a single tax at the individual level; in a C corporation, the sale would be taxed at both the corporate and individual level, as income to the company and as capital gains to the individuals. The amount of the corporate tax would depend in part on the depreciation taken on the assets.

4. The S corporation is creating losses the owners want flowed through to them. In some situations, a company may be making heavy investments, often in real property or other hard assets, that create paper losses. These losses can be flowed through to the owners, who can deduct them at a marginally higher rate than can the company. In some scenarios, this may be desirable.

5. The seller's basis is already very high because of taxes paid on previously undistributed earnings. In this case, the "rollover" provision may not make much difference.

For details on S Corporation ESOPs, see our book S Corporation ESOPs, see Selling to an ESOP and Financing the Deal and the ESOP Pre-Feasibility Toolkit.

Link to this FAQ Topic: S Corporation ESOPs