ESOP Taxation Rules – Q&A

Quick Answers to Common Questions on ESOP Taxation

Can I make a tax-deductible charitable contribution of Qualified Replacement Property?

Employee stock ownership plan (ESOP) taxation rules state that charitable contributions of Qualified Replacement Property are tax deductible under the Code and are not taxable dispositions under the ESOP Taxation rollover rules. Qualified Replacement Property may also be contributed to a charitable remainder trust or annuity, which allows the donor to receive continuing income on a tax-advantaged basis, and removes the property from the donor’s estate for estate tax purposes. Charitable giving techniques can maximize the ESOP taxation and financial benefits of an ESOP rollover.

Can I sell stock to an ESOP in return for a note from the ESOP and still qualify for a tax-free rollover?

ESOP taxation rules say YES. However, the Qualified Replacement Property must be purchased within a 15-month period, beginning three months prior to the date of the sale. If the note has not been fully paid by the time the Qualified Replacement Property must be purchased, the selling shareholder will have to use other funds to purchase enough Qualified Replacement to roll over the entire sale proceeds. Seller-financed ESOP taxation transactions can use floating rate notes to avoid this problem.

Are ESOP participants taxed on their ESOP accounts?

ESOP taxation rules dictate the value of a participating employee’s ESOP account, including company contributions and any appreciation in the value of the account, is not taxable to the employee while it accumulates in the ESOP.

Distributions from the ESOP are subject to ESOP taxation, but favorable tax treatment may apply to lump sum distributions in the form of company stock.

For distributions received prior to age 59-1/2, an additional 10 percent excise tax is generally imposed unless the distribution was made on or after the employee’s death, disability or separation from service after attaining age 55. Deductible cash dividends paid to ESOP participants are not subject to the early distribution excise tax; this favorable treatment under ESOP taxation does not extend to S corporation distributions.

Eligible ESOP taxation distributions may be rolled over into an IRA or another qualified plan, in which case income taxes will be deferred.

When are dividends paid on ESOP shares tax-deductible?

ESOP taxation rules permit a special tax deduction for reasonable dividends on C corporation stock held in the ESOP if they are (i) used to repay an ESOP loan the proceeds of which were used to acquire the employer securities with respect to which the dividends were paid, (ii) distributed in cash to participants no later than 90 days after the close of the plan year in which they were paid, or (iii) paid to the plan and reinvested in company stock. Distributed dividends are taxed as ordinary income.

What is a tax-free ESOP rollover?

ESOP taxation rules benefits of selling to an ESOP: Shareholders who sell their stock to an ESOP can elect to defer federal income taxes on the gain from the sale, if the sale qualifies as a ESOP taxation-free rollover under Section 1042 of the Code.

In order to qualify for the ESOP taxation rollover:

  • The ESOP must own at least 30 percent of the company’s stock
  • The proceeds must be reinvested in Qualified Replacement Property
  • The stock sold to the ESOP must be common stock with the greatest voting power and dividend rights
  • The stock sold to the ESOP must have been acquired as an investment and not in an employment-related transfer
  • The seller must have owned the stock being sold for at least three years
  • The company is not an S corporation

Other things to note about the ESOP taxation-free rollover:

  • The selling shareholder, any 25% or greater shareholder, and certain family members are generally prohibited from receiving allocations of stock acquired through a ESOP taxation-free rollover.
  • A shareholder may elect to rollover all or any portion of the ESOP sale proceeds. The election must be filed with the selling shareholder’s federal income tax return.
  • The company must agree to pay a penalty tax if the ESOP shares acquired through the rollover are sold or disposed of by the ESOP within three years after the date of sale.

ESOP taxation 1042 rollovers and Qualified Replacement Property (QRP): What are the benefits and how can you qualify for them?

The key motivation for many ESOP transactions in closely held companies is the ability of the selling shareholder to defer capital gains tax on the sale of shares to an ESOP under Section 1042 of the IRS Code. One condition of Section 1042 is that the selling shareholder purchase Qualified Replacement Property with a value equal to the amount received in the qualifying ESOP transaction. There is an opportunity for huge ESOP taxation savings but you may not be aware of exactly what you need to do in order to qualify.

Are you ready for year-end?

Whether your ESOP plan year-end corresponds to the calendar year or not, you should always have a checklist ready!

Here are some best practices covering a range of topics:

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What do you need to know about your ESOP taxation reporting?

ESOP taxation reporting is a small but important element of the overall recordkeeping process as it relates to ESOP plan administration. Fortunately, most plans engage the Trustee or Third Party Administrators (TPAs) to bear the administrative burden of the preparation and submission for the 1099-Rs and Form 945 for ESOP taxation. Nonetheless, employer/taxpayer cooperation is vital to ensure a smooth and accurate ESOP taxation process.

Annual ESOP Taxation Reporting and Filing

Form 1099-R is filed for participants receiving distributions of $10 or more from retirement plans or profit-sharing plans, individual retirement arrangements (IRAs), annuities, pensions, death benefit and disability payments made from a retirement plan, and distributions or 404(k) dividends from an ESOP.

Form 945 is filed to report all federal income tax withheld from non-payroll payments or distributions on an annual basis. When filing the Forms 1099-R and 945 the payer, trustee or plan administrator must use the same employer identification number (EIN) and name used to deposit the tax withholdings.

ESOP Taxation and Form 1099-R Reporting Requirements

Form 1099-R contains detailed information specific to each recipient and outlined as follows:

  • The recipient account number is the Social Security number for the individual who received the distribution. For example, if a death benefit distribution was made to a participant’s beneficiary, the beneficiary’s Social Security number and address would be reported on Form 1099-R.
  • The gross distribution amount is reported under Box 1: the total amount of the distribution prior to any tax deductions withheld. The amount in Box 2A is the taxable amount of the distribution; the amount reported would be $0.00 if the distribution amount is transferred to a direct rollover account as the distribution amount is non-taxable under ESOP taxation rules.
  • Federal income tax withheld is reported in Box 4. If state or local income tax is withheld, those amounts are reported in Boxes 12 and 15. The payer’s state identification number is entered into Box 13 along with the abbreviated name of the state.
  • Each distribution has a code that is reported in Box 7; the distribution codes are dependent upon the type of distribution processed. The most common codes reported are as follows:
    • Code 1 {early distribution} – if employee/taxpayer has not reached age 59.5 and there are no known exceptions under Codes 2, 3 or 4
    • Code 2 {early distribution with possible exceptions} – employee/taxpayer has not reached age 59.5 and it is known that the distribution is a Roth IRA conversion (an IRA converted to a Roth IRA), or a distribution from a qualified retirement plan after separation of service in or after the year the taxpayer has reached age 55
    • Code 3 Disability distribution
    • Code 4 Death benefit OR Code 4G as a death benefit rollover distribution
    • Code 7 Normal distribution from a plan, i.e. employee/taxpayer is at least age 59.5
    • Code G Direct rollover and rollover contribution. Code U dividends that have been distributed from an ESOP under section 404(k) governing ESOP taxation.

Form 1099-R Filing Deadlines for ESOP Taxation

All employees/taxpayers that require a Form 1099-R should receive a copy of the Form 1099-R by January 31 for tax filing purposes. The employer has a February 28 IRS deadline to file Copy A of Form 1099-R. The Copy A filing submission to the IRS consists of the red IRS Form 1099-R as well as the Form 1096 Transmittal, which is a summary sheet of all the information contained with the Form 1099-Rs (i.e., total federal taxes withheld, number of Form 1099-Rs submitted, total gross distributions amount, etc.). The Form 1096 Transmittal should be signed by the trustee of the retirement plan that has issued the distributions.

Form 945 Reporting Requirements for ESOP Taxation

Form 945 is used to report federal income tax that is withheld from non-payroll payments to include: pensions, military retirement, gambling winnings, voluntary withholding on specific government payments and backup withholding. All of the federal income tax withheld from non-payroll payments or distributions is to be reported once on a calendar year basis. If an employer/taxpayer withholds federal income tax a Form 945 must be filed; if there is zero federal tax withheld then a Form 945 does not need to be filed.

The Taxpayer Identification Number (TIN) used on the Form 945 must be consistent with the TIN used on the Form 1099-R as the two forms are submitted to the Internal Revenue Service and the federal tax withholding amounts must match one another. Generally the best practice is to use the -plan’s TIN. However, in some cases the sponsor’s TIN or a third-party payer’s TIN is used.

Form 945 Tax Withholding Requirements for ESOP Taxation

Federal deposits made by electronic transfers are usually processed using the Electronic Federal Tax Payment System (EFTPS). This is a free service offered by the Department of Treasury. Other options available for funds transfers are payroll service, financial institution, institutional Trustee, or other third party; all other options may have fees associated with the service. If the Summary of Deposits is less than $2,500, payment can be made by check with the Form 945; otherwise all deposits should be made using an electronic funds transfer system. Payment of less than $2,500 should be submitted with the Form 945 and Form 945-V (payment voucher) with a check or money order made payable to the United States Treasury. The EIN, Form 945 and tax period should be referenced on the check or money order.

There are two deposit schedules that dictate when to deposit federal income tax withheld: semi-weekly or monthly. The associated schedules determine when the deposit is due after the tax liability occurs; before each calendar year a determination must be made as to which schedule will be used. For calendar year 2013, the employer is a monthly schedule depositor if the total tax reported on the 2011 years Form 945 was $50,000 or less. If the total tax exceeded $50,000 on the prior Form 945, the employer is a semi-weekly schedule depositor. Notwithstanding the prior total, if total withholding exceeds $100,000 on any day in a deposit period, the taxpayer immediately becomes a semi-weekly schedule depositor. For these taxpayers, the withholding must be deposited the next day after the tax liability is incurred and Form 945-A must accompany Form 945.

Form 945 Filing Deadline for ESOP Taxation

The Form 945 must be filed by January 31 if a payment is included with the submission. Otherwise, if deposits were timely and full payment of taxes for the year processed, the return can be filed by February 11. All Form 945s are sent depending on two criteria: where the principal place of business is located and whether or not a payment is included with the return.

In most cases the Form 945 is submitted by the owner of the business or the trustee of the qualified plan. There are alternative signature methods available such as corporate officers or duly authorized agents who may sign the Form 945.

Avoiding Potential Pitfalls of ESOP Taxation

Sponsors of ESOPs and other retirement plans should be wary of a few potential pitfalls concerning tax reporting and withholding deposits:

  1. Register for EFTPS even if you have no tax liability or your expected liability is less than $2,500. Registration is free and there are penalties for paying late or failing to pay electronically. It can take up to four weeks to receive your Personal Identification Number (PIN) from EFTPS. Plan ahead and register before you begin processing distributions.
  2. Be aware of any change in your withholding deposit status, e.g., when you first exceed the tax withholding thresholds of $2,500, $50,000 in a calendar year or $100,000 in a deposit period.
  3. Ensure that you’re depositing withholding under the same TIN as you’re reporting on Form 1099-R. If the TIN doesn’t match, the plan sponsor may be subject to penalties for late filing or failure to file and the plan participants may have problems filing their personal tax returns electronically.
  4. Collect Social Security numbers for every beneficiary when paying death benefits.
  5. Return your 1099 data to your TPA in a timely manner. SES sends a template and data request in December. A prompt response to this request helps us to ensure your forms are filed on time.

In conclusion, carefully following these procedures is necessary to avoid penalties for ESOP taxation non-compliance. For example, the failure to file 1099-Rs on time may result in a penalty range of $30 to $100 per form depending on when the forms were filed. Also, failure to prepare and issue the 1099-Rs on time could result in a participant’s need to amend his or her personal tax return.

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