Employee Stock Ownership Plans Are an Overlooked Tax Unicorn

My introduction to employee stock ownership plans was an accident. In the late ’90s, I was working in the consulting group of a large regional CPA firm, and Bill Blass’ namesake company was a client.

Blass had agreed to sell the company, and my firm valued the company’s intellectual property. As part of the engagement, I learned that an employee stock ownership trust was among the shareholders.

I knew nothing about ESOPs at the time, but the concept fascinated me. Most people only thought of these defined contribution plans as employee benefit tools. I realized that an ESOP could also be leveraged as a corporate finance tool to achieve shareholder liquidity. In terms of stakeholder alignment, it was a unicorn.

There were complexities, including ERISA governance and regulatory oversight, but for productive, middle-market companies, the potential upside generally outweighed the costs. Tax incentives were a major driver of these benefits. To this day, I wonder why so many closely held companies—and their outside advisers—overlook ESOP strategies for owner succession and liquidity.

To better appreciate the tax advantages, let’s look at a hypothetical transaction. Consider a California-based business structured as an LLC, where a single shareholder sells 30% equity to an employee trust for $10 million.

Capital Gains Tax Mitigation

Unlike a typical M&A transaction, the shareholder can defer (and potentially eliminate) state and federal capital gains taxes on their sale proceeds. Assuming a 33% combined tax rate for a California resident, in our example that amounts to a potential $3.33 million tax savings. Section 1042 of the tax code makes this possible.

Akin to a 1031 rollover, Section 1042 grants a tax deferral when sale proceeds are reinvested into qualified investments. These “qualified replacement properties”—debt or equity of US operating corporations—must be acquired within a year of the ESOP sale.

To qualify for a 1042 rollover, the sponsor company must be taxed as a C corporation. In our above example, the LLC would be restructured as a C corporation before the sale.

Post-transaction, the selling shareholder invests sale proceeds ($10 million) into a qualified replacement property. The trading of this security is taxable. But if the shareholder holds these securities until death, the investment receives a step-up in basis and can be sold without triggering taxes.

Corporate Income Tax Deductions

When stock is sold to an employee trust, the sponsor company receives tax deductions equal to the fair market value of the equity acquired by the ESOP. Both C and S corporations are entitled to this incentive, but the mechanics differ. In our example, the company (now a C corporation) receives $10 million in deductions to offset future taxable income.

The company receives these deductions over time due to the nature of leveraged ESOP financing. Our hypothetical employee stock ownership trust technically borrowed $10 million from the company to purchase its equity. Stock is allocated to employees as this internal ESOP loan is paid down.

To facilitate repayment, the company will make annual ESOP contributions. Immediately following a contribution, the employee trust returns that cash to the company as a partial repayment on the $10 million loan. This roundtrip ledger entry creates a non-cash tax deduction. Afterward, the cash remains on the company’s balance sheet and can be used for any corporate purposes. Interest payments on this internal loan and optional dividend payments are also tax-deductible.

The $10 million in deductions offers a significant competitive advantage in a place like California. Had the company maintained the status quo and not implemented the ESOP, the owners could have expected an effective tax rate of over 50% on pass-through income.

Following an initial sale, the shareholders may eventually sell additional equity to the ESOP. Upon doing so, the sponsor company generates more tax deductions.

Permanent Non-Taxable Opportunity

Once all outstanding equity is owned by the employee trust, the company can achieve an additional, ESOP-exclusive tax benefit. This may be the greatest competitive advantage afforded to employee-owned companies: becoming a tax-free business.

Employee trusts are tax-exempt as a qualified retirement plan. If an ESOP-owned company makes an election to be taxed as an S corporation, then the ESOP’s share of earnings is non-taxable. As a result, a 100% ESOP-owned S corporation can operate virtually income tax-free in perpetuity.

Although California levies a 1.5% state franchise tax on pass-through entities, the company could still expect a substantial increase in its after-tax cash flow as a 100% S ESOP.

Tax-Deferred Employee Benefits

The equity sold to the employee stock ownership trust will be allocated to plan participants over a period of time established at the sale. In our example, the sponsor company agrees to a 20-year allocation period. Each year, eligible employees receive share allocations proportional to their annual salaries up to defined benefit compensation limits. The plan has vesting rules, much like a 401(k).

When an employee terminates employment, they will have a put option on the fair market value of their allocated stock. The former employee can elect to roll proceeds into another qualified retirement plan rather than face an ordinary income tax upon payment.

ESOP Advantages in Context

While I support the tax advantages afforded by a properly structured ESOP, these benefits are only part of the employee ownership equation. There’s a human element that drives consideration of this strategy and can make an ESOP so profound.

Third-party and private equity sales grab headlines. But the next day, many sellers have a sense of loss, and many employees face uncertainties. Conversely, an ESOP can benefit all stakeholders.

This article does not necessarily reflect the opinion of Bloomberg Industry Group, Inc., the publisher of Bloomberg Law and Bloomberg Tax, or its owners.

Author Information

Lawrence Kaplan is managing partner of CSG Partners, an ESOP investment banking practice.