Shareholder Tax Incentives

Section 1042 Tax Free Exchange
To encourage employee ownership, Congress added Section 1042 to the Internal Revenue Code to provide eligible selling shareholders with the opportunity to sell their shares to an ESOP and defer (potentially forever) tax on the proceeds. As long as the selling shareholder reinvests the proceeds in qualified replacement property (debt or equity in U.S. companies) within the period beginning three months before or ending twelve months after the date of sale, the selling shareholder does not pay capital gains tax on the shares sold to the ESOP. To qualify for Section 1042 tax free exchange treatment, the sale and reinvestment of sales proceeds must be structured to meet the applicable tax rules. If properly structured, the selling shareholder can have almost complete flexibility in the use of the sale proceeds without worrying about triggering capital gain taxation.

Minimize Estate Burden
ESOPs also provide shareholders the opportunity to minimize their estate tax burden. The period immediately following an ESOP sale is an attractive time to implement an estate tax reduction strategy. This is because a leveraged ESOP transaction often will temporarily reduce the value of a company's shares, thereby creating a window of opportunity to make gifts of stock to the shareholder's family. The use of a family limited partnership in conjunction with an ESOP can substantially reduce, if not eliminate, the future estate tax burden. Additionally, if the selling shareholder has a charitable intent, an ESOP combined with a charitable remainder trust is a powerful tax planning and charitable giving strategy.

Company Tax Incentives

Deductible Principal on ESOP Loans
Company contributions to an ESOP are tax deductible. Consequently, a company's contribution to the ESOP to repay a loan used by the ESOP to acquire shares of the Company's stock (an ESOP loan) is tax deductible within certain limits. This results in both the principal and interest on an ESOP loan being deductible, as compared with an ordinary (non-ESOP) loan where only interest is deductible. This tax incentive creates the opportunity to raise tax-efficient capital for acquisition of stock from shareholders or expansion of the business.

Deductible Corporate Dividends
If either used to pay down an existing ESOP loan or passed through to participants, the dividends attributable to stock held by the ESOP are tax deductible by the company.

S Corporation ESOP Planning Opportunities
ESOPs can be particularly effective when combined with a Subchapter S Corporation (or simply "S Corporation"), provided that the ownership of S corporation is not concentrated in too few owners (complicated tax rules deny the benefit of S Corporation ESOPs to certain S Corporation owners). S Corporation ESOPs can create a powerful tool for income tax deferral and capital accumulation within a business. S Corporations are "pass through" entities, meaning their income is not subject to a corporate level income tax. Instead, income is passed through to the company's shareholders, who individually pay tax on the income. Since ESOPs are tax-exempt entities, to the extent that income from the S Corporation is passed through to an ESOP as a shareholder, that income escapes current income taxation at both the corporate and individual levels. Since the corporation doesn't have to distribute any cash to the shareholder to use to pay taxes on income, that money can be kept in the Corporation and used for other (business) purposes. If an ESOP owns 100% of an S Corporation, no income tax will be paid on the corporation's current income (i.e., because the income is allocated to the ESOP, which is a tax-exempt shareholder). However, the tradeoff is that the selling shareholder of an S corporation cannot take advantage of Section 1042 treatments (see above).

Employee Tax Incentives

Additional Retirement Planning
Like other tax-qualified retirement accounts, the growth of the employees' ESOP accounts is tax deferred until retirement. In addition, special tax incentives are available to employees who receive distributions of company stock from the ESOP.

Key Management Tax Incentives

Market for Key Management Stock
When a company proposes a business succession strategy to key management, one question that always arises is "How and when do we eventually cash in our stock?" When properly structured and maintained, an ESOP can provide a perpetual market for each succeeding management generation.

Disclaimer

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