ESOP’s Capital Gains Tax and Tax-deductible Contributions

As many other qualified retirement plans do, ESOPs have a number of tax-friendly features business owners like. For example, contributions made to an ESOP are tax-deductible, within limits. Contributions may include new shares of stock, company cash to buy existing shares or borrowed money to buy stock. If you borrow from an ESOP, both principal and interest paid back are deductible.

Rules Come With These Tax Advantages

To maintain tax deductibility, ESOP sponsors must follow regulations published by the Department of Labor and the Internal Revenue. They include:
  • Contributing to all eligible employees. Generally, you must contribute into the ESOP accounts of all full-time employees age 21 and older who have at least a year of service with the company. This differs greatly from some employee stock option plans, which favor key executives over rank-and-file workers.
  • Making contributions equitably. Plan sponsors may make contributions either as a percentage of salary or in equal dollar amounts to their employees’ ESOP accounts.
  • Permitting employees to vest. Federal law guarantees plan participants assume full ownership of stock in their accounts over time. There are two vesting schedules ESOPs may follow. The first gives 100% vesting all at once after three years. The second method is to gradually vest employees until fully vested after six years. Vesting schedules serve as encouragement for employees to remain with the company – and not move to a competitor – in order to vest in their ESOPs.

Defer Taxes

Some C corporation owners tax-defer profits by selling their stock to an ESOP and rolling over the proceeds into other investments. Others keep their profit and pay capital gains tax on it, which is typically lower than ordinary income tax rates.
If you own a C corporation, you may defer capital gains taxes on stock sold to your company’s ESOP if you follow two conditions. One, the ESOP must own at least 30% of most outstanding shares. Two, as the seller you must roll over money equal to the sale proceeds into certain securities, such as stocks and bonds from U.S. companies. The rollover must occur between three and 12 months after selling ESOP stock.
There is a cost to this tax advantage. ESOP sponsors must have their company stock valued by an independent appraiser to establish a fair market value for the stock.

Game Plan

  • Your benefits department and, if you have one, third-party administrator should stay current on these and other federal and state ESOP regulations.
  • Remember that only C corporations qualify for a tax-deferred rollover of a stock sale. Other corporate types, including an S corporation, don’t enjoy the same benefit.
  • The Internal Revenue Service pays particular attention to ESOP tax issues. They watch to make sure these plans operate for the benefit of all participants, not just a chosen few. Work with an accountant who understands ESOPs to avoid any misunderstandings with regulators or the IRS.
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