ESOPs have been around for years; they could be a solution for ownership transition.

August 16, 2023

Gregory S. Dowell

Possibly you have heard of an ESOP before (no connection to Aesop, the legendary Greek who spun fables filled with wisdom), but they sounded too complicated for your business.  At their best, ESOPs can create a market for a small business, foster a greater degree of employee participation and commitment, and maintain the culture of a business, rather than seeing that culture disappear via a merger.  As business owners struggle with succession planning in a very difficult labor market, it may be time to take a closer look to see if an ESOP might work for you. 

An ESOP is a qualified defined contribution plan that is either a stock bonus plan, or a combination stock bonus and money purchase plan, that invests primarily in a business' stock for the benefit of the plan participants.  After an employer establishes an ESOP, the employer makes annual contributions to the ESOP in the form of stock or cash.  The employer's contributions are tax deductible.  An ESOP may use employer cash contributions to buy common stock from the controlling stockholders, as long as the price reflects the value of the stock.  The stock acquired by the ESOP is allocated to the participants' accounts but, because it is a qualified retirement plan, the amount added to the participants' accounts each year is not included in their gross income; it accumulates tax-deferred until the participant retires, dies, or becomes disabled. 

The ESOP may also borrow to buy the stock (whether from the shareholder, the corporation, or a third party), with the debt being paid out of the employer contributions to the ESOP (these are known as "leveraged ESOPs", versus nonleveraged ESOPs).  The loan can be a direct loan from a financial institution with a guarantee by the corporation, or the loan can be made to the corporation with the corporation re-loaning the funds to the ESOP.  In the case of a stock that is not traded on a public exchange, a valuation will have to be performed on an annual basis. 

An entity has to be a corporation to use an ESOP; a limited liability corporation being taxed as a partnership will not work.  An ESOP is also permitted to be a shareholder in an S corporation. 

A shareholder who sells stock to an ESOP may be eligible to elect to defer having the gain taxed in the year of sale.  To qualify for the tax deferral under Code Section 1042, the following are required:

1. ESOP must own at least 30% of the business' stock immediately after the sale.
2. Selling shareholder must have held the stock for at least three years prior to the sale.
3. Selling shareholder must purchase qualified replacement property within the period beginning three months before and ending 12 months after the date of the sale. 
4. Stock sold to the ESOP must be a qualified security.

If the Section 1042 tax deferral election is made, the selling shareholder is not subject to tax on the gain attributable to the sale of stock, and the tax basis for the qualified replacement property is the same as the selling shareholder’s tax basis for the stock that was sold to the ESOP. Taxable gain is recognized if and when the qualified replacement property is sold or otherwise disposed of. If the qualified replacement property is retained by the selling shareholder until his or her death, the gain on the stock sale to the ESOP will completely escape income taxation because of the Section 1014 basis step-up, although the qualified replacement property will be included in the decedent’s taxable estate according to the usual estate tax rules. Thus, Code Section 1042 and the provision for qualified replacement property allow closely held corporate shareholders to create a diversified investment portfolio without incurring income tax in the short term.

While and S corporation can adopt an ESOP, the shareholders of an S corporation can not elect to defer the tax on the gain under Code Section 1042.

The 30% ownership test is satisfied if, immediately after the sale to the ESOP, the ESOP owns either 30% or more of each class of the corporation’s outstanding stock or 30% or more of the total value of all of the corporation’s outstanding stock.  The 30% test does not mean that each selling shareholder must sell at least 30% of his interest. Instead, the view is from the ESOP level. That is, after any given shareholder sale, the ESOP must own at least 30% of the employer stock. Once the ESOP achieves 30% ownership, the subsequent sale of any amount of stock would satisfy the 30% test.

Another feature of these plans is the shareholder's right, each year, to direct the plan as to the investment of at least 25% of the account balance once the shareholder has reached age 55 with at least 10 years of plan participation. This “diversification of investments” election permits older employees to select investments suitable for their anticipated retirement. If the ESOP is part of a larger plan, like a profit sharing plan, that permits employee contributions, the shareholder may be able to divest the employer stock and allocate it to other plan investments once the shareholder has completed three years of service as a participant.

If employment terminates, there is an ESOP distribution rule which is meant to accelerate the date when benefits can begin.  ESOP benefit payments must begin no later that one year after the end of the plan year when separated from service on account of retirement or disability, or one year after the end of the plan year that is the fifth plan year following separation from service from some other cause. Since these rules are meant to speed up the date benefits begin, if benefits would begin sooner under the distribution rules applicable to all qualified plans, then that would override the ESOP rules.

For 2023, the limit on contributions to defined contribution plans, including contributions to the ESOP, are limited to the lesser of $66,000 or 100% of compensation. However, certain forfeitures and payments of interest on loans to the ESOP will not be taken into account in calculating these limits which may have the effect of increasing amounts that go into a shareholder's account.

Establishing ESOP plans is not inexpensive.  There are significant upfront costs with attorneys and consultants, as well as ongoing costs of compliance and valuations.  ESOPs are qualified plans, which means that regulatory compliance must be prioritized annually. 

All that said, ESOPs in the right setting can provide tremendous benefits to small businesses, their shareholders, and their employees.  Whether an ESOP is right for your business will depend on all of the facts and circumstances, but well may be worth the analysis.