ESOP Taxation Rules for Established Employee Owned Companies – Q&A

Quick Answers to Common Questions on ESOP Taxation for ESOP Company CFOs and Finance Managers

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.

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.

Interested in the services we offer for established ESOP companies? Reach out for more information or learn more about ESOP services for companies that are already employee owned.