Enterprise Services, Inc. Business Transitions and Valuations
ESOP Articles

Written by Scott Miller, CPA/ABV, CVA

Published in The Wisconsin CPA, a publication of the Wisconsin Institute of Certified Public Accountants, January 1999 and in The Valuation Examiner, a publication of the National Association of Certified Valuation Analysts, February/March, 1999.

Recently enacted legislation by Congress now makes it possible for a Subchapter S corporation to have an Employee Stock Ownership Plan and Trust ("ESOP"). The legislation favorable to ESOPs was passed during 1996 and 1997 and became effective for plan years beginning January 1, 1998. Until this legislation, only a "C" corporation could have an ESOP. The development is significant because there are far more subchapter S corporations ("S corporation") in the country. The relative attractiveness of an ESOP prior to 1998 was limited by the requirement that the plan sponsor, or the employer, had to be a C corporation.

Historical Perspective

The significance of the new legislation is better understood with a brief review of the history of ESOPs. The Employee Retirement Income Security Act of 1974 ("ERISA") was passed by congress largely in response to a number of notorious private pension fund failures. The privately managed retirement system in the United States was substantially unregulated prior to ERISA. While many retirement programs were professionally managed, others were not, and ERISA mandated a rigorous set of standards for the administrators of the retirement plans.

One key provision of ERISA is that virtually all qualified retirement plans must have a trust that typically owns the plan assets for the benefit of plan participants. The trust is managed by a trustee (or trust committee) that has certain fiduciary responsibilities to the plan participants. Generally, the trustee must act in the exclusive best interests of the plan participants, which is a rigorous standard of behavior.

ESOPs in "C" Corporations

It is generally acknowledged that ESOPs were created with the passage of ERISA. In this venue, ESOPs enjoy many of the advantages of other qualified retirement plans. One principal advantage of a qualified plan is that assets contributed to the plan may compound and grow free of all taxes until the assets are withdrawn, generally at retirement age. Originally, only a C corporation could have an ESOP, because there were legislated barriers that did not permit S corporations to have a trust as a shareholder.

Another advantage that any contribution of either cash or employer stock to the ESOP within certain prescribed qualifying payroll limits is deductible for tax purposes. With proper structure, this meant that a leveraged ESOP (an ESOP that borrowed funds to purchase stock) could repay its debt principal with tax deductible dollars. If the company is in an effective 40% tax rate, the ability of the ESOP to deduct debt principal produces substantial tax savings (e.g. $1,000,000 in debt x 40% = $400,000 in tax savings during the amortization of the loan).

A specific advantage to an ESOP in a C corporation is that a shareholder selling stock to the ESOP may qualify for an Internal Revenue Code Section 1042 "tax free rollover" of the proceeds received from the sale. To qualify for the tax free rollover, the ESOP has to own at least 30% of the outstanding stock after the transaction is completed. The tax free rollover is a powerful incentive because a selling shareholder is typically exposed to a 20% capital gains tax on the taxable sale proceeds. The proceeds from the sale to the ESOP have to be reinvested (rolled over) into qualified domestic securities for the tax deferral.

Finally, the other major advantage to an ESOP in a C corporation is that multiple classes of stock may be used to effectively increase the tax deductible contributions to an ESOP beyond normally established payroll limits. Dividends may be contributed to the ESOP in a manner that makes them deductible for tax purposes.

ESOPs in "S" Corporations

Many of the above benefits of an ESOP in a C corporation are also benefits in a S corporation. For example, contributions to the ESOP of cash or stock are deductible for tax purposes in both a C and S corporation. The key point is that the amounts that are deductible differ depending on the tax status of the company. Generally, the payroll limit for a leveraged ESOP in a C corporation is 25%, and the contribution may be applied entirely to ESOP related debt principal since interest expense is generally deductible on its own. A leveraged S corporation my only deduct up to 15% of qualifying payroll, and this percentage includes both ESOP related debt principal and interest. A money purchase plan may be combined with the S corporation ESOP to effectively increase the payroll percentage, but this will introduce a level of complexity to the transaction.

The Section 1042 tax free rollover is not available to the shareholders in a S corporation. Any gain on the sale of stock to an ESOP in a S corporation is taxable to the selling shareholder. This is a disadvantage, but correspondingly, many restrictions that accompany a Section 1042 transaction do not apply in a S company.

One significant advantage of the an ESOP in an S corporation is that the pre-tax income allocated to the ESOP on a prorated percentage of stock ownership is not subject to federal income taxes. This is because the ESOP ("trust") owns the actual stock of the employer, but the ESOP does not pay taxes. The income of the company is not allocated to individual participants in the plan. For example, if the ESOP owns 80% of the outstanding stock and the company has $1,000,000 in pre-tax income, then 80% of the pre-tax income, $800,000, is exempt from income taxes. Only the remaining 20% is subject to taxes payable by the remaining individual shareholders. This is a significant tax saving for the company, and allows the S corporation to potentially retain substantial earnings for worthwhile business uses.

The new legislation raises the number of shareholders permitted in an S corporation to 75, and the ESOP only counts as a single shareholder. This feature will increase the number of S corporations that will find an ESOP attractive. Finally, the S corporation may not deduct dividends paid to the ESOP. The major benefits and differences between C corporation and S corporation ESOP have been discussed in this article. The actual technical provisions of the legislation are much more complex, and it is recommended that experienced professional advisors be consulted if there is further interest in this topic.


Legislation impacting employee ownership and ESOPs has greatly expanded the incentives and opportunities over time. Since 1974 there is a discernible and pronounced effort to encourage greater employee participation in our market based economy. Congress took another significant step in this process in 1998 by extending ESOPs to S corporations. It is now the situation where most closely held corporations may consider an ESOP as a viable option.

Enterprise Services, Inc. Business Transitions and Valuations
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