An Employee Stock Ownership Program or ESOP is a way for owners to share the wealth and success of a company with employees. It is often used for succession planning allowing long-term employees a way to buy out an aging owner and continue the business. ESOPs also offer some tax incentives to the company such as using deductible funds when servicing debt and creating deductible cash dividends.
Tax Deductible Debt Service
The IRS allows C corporations to take a deduction for dividends paid on ESOP stock if the dividends are used for specific purposes. This deduction is only available if the dividends are paid directly to plan participants or to the ESOP or reinvested in employer stock. The deduction is also available if the funds are used by the ESOP to make payments on a loan used to acquire employer stock. In order for these dividends to be deductible, the dividend must be reasonable. These dividends are disallowed, however, if the IRS decides that the dividends are solely for the purpose of tax evasion.
This tax incentive is designed to encourage companies to set up and invest in ESOP plans. Further, dividends used to repay ESOP loans are not considered when determining how much each plan participant can otherwise receive in qualified retirement plans. Nor are ESOP dividends calculated into a participant’s maximum contribution amount (allowing participants to grow retirement savings even faster).
An ESOP can also purchase convertible preferred stock, which requires a regular dividend be paid while common stockholders are paid only at the discretion of the board. This allows companies to set up an ESOP and use dividends to fund the transaction without paying the same dividend to all shareholders.
Tax Deductible Cash Dividend
Most dividends paid by ESOPs are pass-through dividends and are taxed at the individual’s tax rate. An employee may have both vested and unvested shares of the ESOP. If pass-through dividends are calculated based only on vested stock, then the dividends on unvested stock can also be used to repay an ESOP loan and thus are deductible to the company. Dividends can also be used to reinvest in employer stock and any stock purchased by dividends is 100% vested.
Using the cash from dividends is only one advantage of setting up an ESOP. Being able to provide employees with a further benefit in the form of company ownership, without this counting as part of their regular retirement package, is also important.
If your company is interested in organizing an ESOP or looking at options for repaying debt, the benefits attorneys at Hall Benefits Law can help. We work with clients across the country who are looking at the best ways to reward employees, provide quality benefits, comply with the ever-changing legal and regulatory landscape, and grow their company. Give us a call 678-439-6236 today or visit the Hall Benefits Law website to learn more.
Hall Benefits Law, LLC
