One important element when considering partially or fully selling your company to an Employee Stock Ownership Plan (ESOP) are the many tax benefits that can be achieved.
As opposed to traditional M&A third-party sales or succession to children, ESOP companies receive major tax advantages, among other potential benefits. These tax advantages associated with ESOPs can be significant and provide cash flow and reserve for future use.
Read on to find out the seven most substantial tax benefits for ESOP companies:
Tax Deductible Stock Contributions
Stock contributions made to ESOP accounts are tax deductible. Companies can improve their cash flow by issuing new shares to the ESOP, although adding new shares will dilute the existing shares.
Tax Deductible Cash Contributions
Cash contributions to the ESOP accounts are also deductible. A company can put cash into the ESOP fund to buy shares from current owners or to build up a cash reserve and take a deduction for it.
Tax Deductible ESOP Loan Contributions
If a loan is used to fund the ESOP, contributions to repay it are tax-deductible. This means ESOP financing is done using pre-tax dollars which is advantageous to cash flow.
C-Corporation Tax Deferral
C-Corporations can get advantageous tax treatment under an ESOP. If an ESOP owns at least 30% of the shares of a C-Corporation company, the seller can defer taxes on the proceeds of the sale as long as they reinvest in other qualified securities.
S-Corporation Income Tax Nirvana
As an S-Corporation, the percentage of company stock owned by the ESOP is not subject to federal or state income taxes. If an S-Corporation is fully owned (100%) by the ESOP, all the income is tax free. This additional cash flow can be used to repay any transaction debt, fund capital improvements, or make strategic acquisitions with pre-tax dollars.
Tax Deductible Dividends
Dividends paid to ESOP shareholders are tax deductible. Dividends can be used to repay the ESOP loan, passed through to employees, or reinvested in company stock.
Tax Deferred Retirement Contributions for Employees
As with some other qualified retirement plans, employees do not pay taxes on the contributions made to the ESOP until they withdraw it. The employees are also able to roll over the distributions into an IRA or other retirement plan. It is subject to a 10% penalty if made before normal retirement age.
In summary, being partially or fully owned by an ESOP can have tax benefits and allow companies to have favorable cash flow as a result. This is one of the many reasons that business owners choose to sell their company to an ESOP rather than through a traditional M&A route.