ESOP Taxation - ESOP Tax Rules Knowledge Center
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ESOP Tax Rules

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ESOP Tax Rules are what keep your ESOP in compliance with government regulators. ESOP tax rules are critical to keeping your ESOP (employee stock ownership plan) viable for the long haul.

ESOP Tax Rules: Establishing an ESOP

ESOP Tax Rules on establishing an ESOP in the United States kick in when a firm sets up a trust and makes tax-deductible contributions to it. Each ESOP is different, though typically plans include all full-time employees with a year or more of service. The ESOP can be funded by tax-deductible corporate contributions to the ESOP.

ESOP discretionary annual cash contributions are deductible for up to 55 percent of the pay of plan participants and are used to buy shares from selling owners. Alternatively, ESOPs can borrow money to buy shares, with the company making tax-deductible contributions to the plan to enable it to repay the loan. Contributions to repay principal are deductible for up to 25 percent of the payroll of plan participants; interest is always deductible. Dividends can be paid to the ESOP to increase this amount over 25 percent. Sellers to an ESOP in a closely held company can defer taxation on the proceeds by reinvesting in other securities.

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ESOP Tax Rules: ESOPs in S Corporations

ESOP Tax Rules governing S corporations dictate that the extent to which the ESOP owns shares in an S corp, that same percentage of the company’s profits are not taxed: 100 percent ESOPs pay no federal income tax, but the profit distribution to the participants is taxed, just as in any S corporation. Employees do not pay taxes on the contributions until they receive a distribution from the plan when they leave the company; taxes can be deferred by the departing employee by rolling the amount over into an Individual Retirement Account (IRA).

ESOP Tax Rules: ESOP Vesting

ESOP Tax Rules on vesting allow ESOP accounts to vest over time, typically following one of two formulas: in the first, vesting starts at two years and completes at year six; in the second, participants becomes 100 percent vested after four years. When employees leave the company, they receive their vested ESOP shares, which the company or the ESOP buys back at an appraised fair market value. ESOP participants are required by law to be allowed to vote their allocated shares at least on major issues, such as closing or selling the company, but are not required to be able to vote on other issues, such as choosing the boards.

ESOP Tax Rules: ESOP Distributions

ESOP Tax Rules dictate that distributions may be made in a lump sum or in substantially equal payments (not less frequently than annually) over a period no longer than five years (i.e., six payments over five years). However, this five-year period may be extended an additional year (up to a maximum of five additional years) for each $210,000 or fraction thereof by which a participant’s benefit exceeds $1,050,000. Distributions are made in the form of cash or stock. These are the 2014 limits; they are adjusted annually.

Employees pay no tax on stock allocated to their ESOP accounts until they receive distributions, at which time they are taxed on the distributions. If they are younger than age 59½ (or age 55 if they have terminated employment), they, like employees in qualified plans generally, are subject not only to applicable taxes but also to an additional 10% excise tax unless they roll the money over (i.e., transfer it) into an IRA (Individual Retirement Arrangement) or a successor plan in another company (or unless the participant terminated employment due to death or disability).

If ESOP money is rolled over into an IRA or successor plan, the employee pays no tax until the money is withdrawn, at which point it is taxed as ordinary income. Rollovers from ESOP distributions to IRAs are available for distributions of stock or cash over periods of less than 10 years.

As with other tax-qualified retirement plans, an ESOP distribution can be rolled over into a “traditional” (regular) IRA or a Roth IRA.

When dividends are directly paid to participants on the stock allocated to their ESOP accounts, such dividends are fully taxable, although they are exempt from income tax withholding and are not subject to the excise tax that applies to early distributions.

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ESOP Tax Rules: ESOP Pre-1987 Rules

These ESOP Tax Rules summarize the special rules enacted for ESOPs in the Tax Reform Act of 1986. Employer stock the ESOP acquired before 1987 may be distributed according to the rules governing qualified benefit plans in general. Depending on circumstances, these rules often allow distributions to occur later than under the special ESOP tax rules; for example, a participant may leave now but wait many years until he or she reaches retirement age to receive the pre-1987 stock.

ESOP Tax Rules: ESOP Diversification

ESOP Tax Rules allow ESOP participants who have reached age 55 and have participated in the plan for ten years, the right during the following five years to diversify up to a total of 25% of company stock that was acquired by the ESOP after December 31, 1986, and has been allocated to their accounts; during the sixth year, they may diversify up to a total of 50%, minus any previously diversified shares. To satisfy the diversification requirement, the ESOP must (1) offer at least three alternative investments under either the ESOP or another plan such as a 401(k) plan or (2) distribute cash or company stock to the participants.

ESOP Tax Rules are diverse, detailed and very important! Don’t leave your ESOP tax management to anyone else. Let the ESOP experts at SES Advisors keep you in compliance. Click here to learn more!

Can I make a tax-deductible charitable contribution of Qualified Replacement Property?
Charitable contributions of Qualified Replacement Property are tax deductible under the Code and are not taxable dispositions under the ESOP 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... Read More

Can I sell stock to an ESOP in return for a note from the ESOP and still qualify for a tax-free rollover?
Yes. However, the Qualified Replacement Property must be purchased within a 15-month period, beginning 3 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... Read More

Are ESOP participants taxed on their ESOP accounts?
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 taxation, but favorable tax treatment may apply to lump sum distributions in the form of company... Read More

When are ESOP dividends paid on shares tax-deductible?
A special tax-deduction is permitted for reasonable ESOP 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... Read More

What is a tax-free ESOP rollover?
A tax benefit 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 tax-free rollover under Section 1042 of the Code. In order to qualify for the rollover: The ESOP must own at... Read More

ESOP Taxation: 1042 Rollovers & Qualified Replacement Property (QRP): What are the Benefits & How Can You Qualify for Them?
ESOP Taxation: 1042 Rollovers & Qualified Replacement Property (QRP): What are the Benefits & 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... Read More

Are You Ready for Year-End?
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! Mychelle and Kelly, two of our ESOP Administrators with more than two decades of plan administration experience between them, give you some best practices and cover a range of topics, including:... Read More

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