An ESOP provides tax benefits for the company (which may vary depending on its status as either a C corporation or an S corporation) and the selling shareholder. First, an ESOP provides a company with a tax deduction equal to the amount of the annual contributions it makes to the ESOP. Second, an ESOP provides a C corporation with the ability to deduct dividends it pays on ESOP shares. Third, § 1042 of the Code provides a shareholder who sells C corporation stock to an ESOP the ability to reinvest the proceeds he receives from the ESOP sale in “qualified replacement property” without immediately paying income tax on those proceeds. Finally, an ESOP provides a method by which a 100% ESOP-owned S corporation can essentially operate as a tax-exempt entity.
Tax-Deductible Contributions. An ESOP is a qualified retirement plan, so its sponsoring employer receives a tax deduction for the amount of its annual contribution to the plan, up to certain limitations imposed by the Code. Because an ESOP company can use tax-deductible dollars (as a result of the “cash-neutral” circular flow of funds described above) to make payments on the Outside Loan, the company effectively converts some or all of what is normally a non-deductible loan principal payment into a tax-deductible contribution to a qualified retirement plan. Therefore, a leveraged ESOP allows the sponsoring company to repay the entire loan – both interest and principal – on a tax-deductible basis.
Tax-Deductible Dividends. Suppose that a company’s annual debt service would exceed its 25%-of-pay limitation under the Code. For example, assume that a company’s principal payment on its Outside Loan is $300,000 and its eligible payroll is $1,000,000. The company would like to take full advantage of the tax benefit discussed above, but the company’s deduction is limited to $250,000 which is $50,000 less than the company’s Outside Loan payment. If the company is a C corporation, it can make a tax-deductible dividend payment on the ESOP-owned shares and the ESOP would use that dividend to pay a portion of the Inside Loan. § 404(k)(2)(A) of the Code provides four instances in which a C corporation can deduct a dividend it pays on shares held by its ESOP. For most ESOP companies, the most useful of these instances is that a C corporation can deduct dividends paid on ESOP shares to the extent the ESOP uses the dividend to make payments on the Inside Loan (which the company will then use to make Outside Loan payments). This provision is the only place in the Code where a company can receive a deduction for dividends paid. Returning to the example above, the company can make an ESOP contribution in the amount of $250,000 and pay dividends on the ESOP shares in the amount of $50,000. The ESOP will make an Inside Loan payment in the amount of $300,000, the company will make payments on the Outside Loan (and Seller Note, if applicable) in that same amount, and the company will receive an income tax deduction of $300,000.
1042 Tax-Deferred Reinvestment. § 1042 of the Code provides that a selling shareholder can elect not to recognize his gain on a sale of stock to an ESOP if certain requirements are satisfied. The threshold requirements of this nonrecognition provision are that the selling shareholder must have held the stock for at least three years prior to the sale to the ESOP, and he cannot have received the stock under a compensatory stock arrangement, such as a stock option plan.
An additional requirement of the tax-deferred reinvestment concerns the type of securities that the ESOP purchases. The ESOP must purchase “qualified securities” under § 1042(c)(1) of the Code, and the central requirement of this definition is that the shareholder must sell C corporation stock to the ESOP. Therefore, this nonrecognition treatment is not available to shareholders of S corporations.
Another requirement is known as the “30% Ownership Test,” and requires that immediately after the sale, the ESOP must own at least 30% of each class of the company’s outstanding stock, or at least 30% of the total value of all of the company’s outstanding shares. This test looks only at the ESOP’s ownership following the sale; so long as the ESOP owns 30% of the company’s stock immediately after the sale, each of the selling shareholders can elect nonrecognition treatment on his individual sales proceeds, even though he did not individually sell at least 30% of his stock.
Another requirement for tax-favored treatment under § 1042 of the Code is that the selling shareholder must reinvest his sales proceeds in “qualified replacement property” (QRP) within a 15-month period beginning three months before the date of the sale and ending 12 months after the sale. The Code defines QRP to mean “securities” (as defined in § 165(g)(2) of the Code) that are issued by a domestic operating corporation other than the corporation that issued the stock involved in the transaction. Generally, QRP includes common and preferred stock, corporate fixed rate bonds, and corporate floating rate notes. The following investments do not constitute QRP: certificates of deposit, mutual funds, municipal bonds, U.S. government bonds, and foreign securities.
Note that the 15-month replacement period is measured from the date of the transaction, not the date the selling shareholder receives his sales proceeds. Thus, if a portion of the ESOP transaction is financed with a Seller Note, the selling shareholder may need to purchase QRP prior to receiving all of his payments on the Seller Note. For this reason, installment sellers often purchase corporate floating rate notes on margin to satisfy the QRP replacement period requirement. For example, assume a shareholder sells $10,000,000 of company stock to an ESOP, financed with an Outside Loan in the amount of $4,000,000, company cash in the amount of $2,000,000, and a Seller Note in the amount of $4,000,000. The selling shareholder receives $6,000,000 in cash at closing, and he can purchase $10,000,000 of floating rate notes as QRP with the cash plus $4,000,000 of margin debt. He can pledge a portion of his QRP as collateral against the $4,000,000 he borrows. Banks often will lend up to 90% of the value of a high-quality portfolio of floating rate notes.
If all of the requirements of § 1042 of the Code are satisfied, the selling shareholder will not be taxed on his ESOP sales proceeds and his tax basis in the stock he sold to the ESOP is transferred to the QRP. Thus, § 1042 of the Code actually provides the selling shareholder with a deferral of tax, not a forgiveness. The selling shareholder will recognize gain in the year he sells or disposes of the QRP. However, many selling shareholders attempt to structure their QRP portfolio so that they hold their QRP until death at which time the QRP will receive a stepped-up basis under § 1014 of the Code, effectively converting their tax-deferred sale to the ESOP into a tax-free sale.
S Corporation ESOP Tax Benefits. The final tax benefit that is unique to ESOP companies is available only to S corporations that sponsor ESOPs. To the extent of the ESOP’s ownership of S corporation stock, the company’s earnings will not be subject to federal income tax. Thus, the income produced by a 100% ESOP-owned S corporation will not be subject to tax because it is a “flow-through” entity whose income flows through to its sole shareholder, the ESOP trust, which is a tax-exempt entity. This is a very powerful tax incentive that essentially allows for-profit corporations to operate on a tax-exempt basis.