There are numerous tax incentives for Corporations to create ESOPs and for business owners to sell stock to an ESOP, along with a number of ERISA rules which must be followed in order to make sure that the sale process is handled fairly
Why sell stock to an ESOP?
The tax law has several tax incentives for business owners to sell stock to an ESOP including a deferral of all gain on the sale of stock, and in many cases for the corporation owned by the ESOP to be exempt from paying income taxes after the sale to an ESOP
Can 401(k) plan assets be used to sell stock to an ESOP
Almost 20% of all ESOPs are a combination 401(k) and ESOP plan and 401(k) assets can be used to help fund an ESOP puchase.
How do ESOPs avoid paying taxes legally?
A corporation which is 100% owned by an ESOP can make an S election if the requirements of 409(p) are met. A S corporation in most jurisdictions does not pay any federal or state level income taxes, and all the taxable income is passed through to the shareholder. The ESOP trust as a tax exempt shareholder is also exempt from Unrelated Business Taxable Income Under IRC Code 512.
How do business owners avoid paying income taxes on the sale of stock to an ESOP?
If an ESOP owns 30% or more of the stock after the sale to an ESOP, under IRC Section 1042, the gain can be deferred if the proceeds are reinvested into qualified stocks and bonds
What should I be concerned about when selling stock to an ESOP and picking an ESOP provider?
The Department of Labor reviews the sale of stock to most ESOPs. You should assume that your transaction will one day be audited by the DOL. Always have an independent trustee who has their own financial and legal advisors representing them. The DOL is very focused on the management forecasts and the ability of the corporation to meet management forecasts after the sale. Avoid those who encourage you to increase future forecasts of profitability in order to obtain a higher price on the sale, or use valuation gimmicks to sell the stock at too high a price to an ESOP, or who seem to have ESOP advisors who are not independent from the seller or the person putting the deal together for the business owner.
How do i find out more about how ESOPs work?
The National Center for Employee Ownership has numerous guides on the Web and seminars where you can find out more information; choose providers who are independent of one another and who you feel comfortable with and who have at least 10 to 15 years experience working with ESOP plans.
Is it required to have an independent trustee in an ESOP transaction?
The statutes do not specifically require an independent trustee, but the DOL when investigating cases, and the courts when reviewing ESOP transactions look carefully at the ESOP purchase decision process, and if the ESOP Trustee is related or subordinate to the business owner, or the advisor who puts together the ESOP transaction for the business owner, the transaction and the purchase price is more likely to be set aside by a Court.
What is the role of an ESOP Trustee?
An ESOP trustee must act in the best interest in plan participants to make sure that the ESOP plan does not overpay for the stock, and receives control in fact of the stock sold, if the ESOP trustee pays for control of the shares. Under ERISA, the process that the ESOP trustee goes through is closely reviewed, and they should go through the same procedures as any third party purchaser would do when buying stock in a Corporation, and keep good records of how they documented that process. The most important thing is for the ESOP trustee and all of it's advisors to be independent in fact from the business owner, and the advisor to the business owner.
Additional resources provided by the author
National Association for Employee Ownership NCEO.org
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