An employee stock ownership plan (ESOP) is a type of qualified plan that has important tax consequences for both employers and employees. Whether you're an employer or an employee, knowing how an ESOP offers tax advantages can help you make the best use of this type of retirement plan.
What Is an ESOP?
As a tax-qualified retirement plan meeting the requirements of federal tax law and regulations, an ESOP gives employee participants an ownership interest in their employer. An ESOP is a type of stock bonus plan; a defined contribution retirement plan that is designed to be funded with employer stock.
ESOPs benefit employers because they can create and encourage employee motivation, provide a ready market for retiring executives' stock, help solve liquidity problems when a major stockholder dies, and promote objectives such as increasing cash flow and helping to finance another corporation.
Tax Consequences for Employers
Contributions to ESOPs offer employers tax deductions and favorable tax treatment of certain stock-related transactions.
Contributions by the Employer
Employer contributions to an ESOP are deductible in the year they are actually made to the plan. The contribution can consist of cash or the employer corporation's stock. If a contribution is made in stock, the employer won't recognize any gain or loss on its taxes.
An employer's tax-deductible contribution to an ESOP is limited to 25% of the compensation paid or owed during the tax year to all of the plan's beneficiaries. In calculating this limit, the maximum compensation of an employee taken into account is $345,000 (in 2024; this limit increases most years). If the contribution is more than the limit for a given year, the excess amount can be carried forward to future tax years.
Dividends on Employer Stocks
Additional deductions are allowed to employers for dividends paid on the employer's stocks that are held by a plan. A C corporation is allowed a deduction for "applicable dividends" paid in cash. An applicable dividend is one that:
- is paid in cash directly to plan participants or to their beneficiaries, or
- is paid to the ESOP and is distributed within 90 after the close of the plan year in which the dividend is paid, or
- is paid to the plan and reinvested in qualifying employer securities (if the participants are given the choice between having the dividends reinvested or receiving them in cash), or
- is used to make payments on a loan that was used to buy the stock that generated the dividend.
Additional regulations apply to deductions for dividends on employer stock.
Deductions and Leveraged ESOPs
The deduction is unlimited if an employer's ESOP contributions are used to pay interest on a loan of a leveraged ESOP. A leveraged ESOP is one that borrowed funds to buy qualifying employer stock. The deduction is allowed if the interest was on a loan used to buy the employer's stock.
Limits on Annual Additions
Under Internal Revenue Code (IRC) § 415(c)(1), the annual addition to a plan participant (consisting of the employer's contributions, the employee's contributions, and forfeited amounts) is limited to $66,000 or 100% of the participant's compensation, whichever is less.
Tax Consequences for Employees
Beneficiaries of ESOP plans are taxed in the year that amounts are distributed or made available to them.
Are ESOP Distributions Subject to Capital Gains Tax?
ESOP distributions are taxed as ordinary income, but if you receive a lump-sum distribution in the form of stock, you'll generally pay ordinary income tax on the value of your employer's contributions to the plan, plus capital gains tax on the appreciation in stock value when the stock is sold. (In other words, the taxable amount is the difference between the property's fair market value and your cost basis in the property.)
ESOP distributions can be made in a lump sum or in substantially equal payments (annually or more frequently). Installment payments must be made within five years or less.
ESOP Early Distribution Penalty
If you receive a distribution from an ESOP before you are age 59 ½, the distribution will be subject to a 10% early distribution penalty tax (unless the distribution is due to disability, medical expenses, child support, or a few other exceptions).
Taxes on Dividends Paid to Employees
There is no 10% early distribution tax on distributions that are dividends from an ESOP, even if you receive them before age 59 ½.
ESOP Rollover Rules
A tax-free rollover of an "eligible rollover distribution" from an ESOP is allowed under IRC § 402(c)(1). Amounts rolled over from an ESOP are not taxed as your income, if the rollover is made within 60 days of the ESOP distribution. You can transfer the distribution to an individual retirement account (IRA), an individual retirement annuity, or to another employer's qualified retirement plan. Amounts you receive from an IRA or annuity are then taxed as ordinary income.
Post-1992 eligible rollovers are subject to a 20% withholding tax, even if it's completed within the allowed 60-day time period. You can avoid withholding with a direct transfer between the ESOP and the rollover IRA or annuity. The ESOP administrator should give you advance written notice of your rollover options.
