Selling to an ESOP: What Exactly Are the Tax Advantages?

“The tax savings generated by a sale to an ESOP can be equal to the total value of the stock sold.”

In my last post, I offered a quick picture of what ESOPs are all about.  As part of that overview, I made the claim that, as a rule of thumb, a stock sale to an ESOP can produce tax savings that equal the entire price paid for the stock.  That’s good, because it’s the company that puts up the money that the ESOP will use to buy stock from an owner (employees don’t pay out of pocket); so we will want to see that expense offset by gains somewhere else.   So what’s the breakdown, exactly?  Here goes.

The tax savings are spread among three parties:

•  The Company.  If a company simply buys back stock from a shareholder, that expenditure is not tax-deductible.  After all, when an investor puts money into a company by buying stock, that inflow is not taxable as income.  Likewise, if/when that flow is reversed (the company buys back the stock), that outflow is not a deductible expense.  Fair enough.  But, if a company sets up an ESOP and gives it money to buy stock from a shareholder, that expenditure becomes tax-deductible.  That’s because it is accounted for not as a cost of redeeming stock, but as a contribution to a qualified retirement plan.  The result is that the taxes due on the company’s profits go down.  Essentially, the government is saying “don’t send us that money; put it toward the cost of buying back stock instead.”

How much is that worth?  It will depend partly on the applicable income tax rate in the state where the income is reportable.  Some states have no state income tax; others go as high as 9 percent.  The average state rate is around 6 percent.  So, in the average state, combined federal and state tax rates run a total of about 40%.  The deductibility of money going to buy stock through an ESOP, then, saves about 40% of the transaction cost in the average state, in reduced federal and state income taxes.

•  The seller.   One nice thing about selling stock is that you only have to pay capital gains rates on your gain, rather than ordinary income rates.  That’s good.  But a sale to an ESOP can go one better.   Tax code section 1042 allows the selling shareholder to avoid paying any tax on the proceeds of a stock sale to an ESOP – if the seller reinvested the sales proceeds in “replacement securities.”  This provision is known as the “1042 rollover” – and it lets you defer all taxes on a sale to an ESOP.  In the average state, this saves you taxes worth more than 20% of the sale proceeds.

There are some conditions:

–          The company must be a C corporation (so an S corp would first have to convert to a C corp).

–          The ESOP must own at least 30% of the company’s stock after the sale has closed.

–          Within 12 months after the stock sale, the seller must reinvest the sales proceeds in any corporate stocks or bonds of American-based operating companies.

• §The employees.   Tax savings also go to the company’s employees.   Many companies issue equity incentives to employees (think Silicon Valley) in order to motivate higher performance.  But, if the company simply gives stock to them directly, the value of that stock would be taxable to them as compensation, reportable on their W-2s.  But when they get stock via an ESOP, it’s not.  Employee tax brackets vary, but your better paid people will (once again in the average state) be saving about 40%.

All told, these tax savings will add up to about 100% of the value of the stock that the owner sold to the ESOP.

Questions?  Put them in a comment and I’ll try to respond in next week’s post.

Next week’s topic: What’s it like Living with an ESOP?

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Martin Staubus is with the Beyster Institute (part of the Rady School of Management at UC San Diego) where he advises company leaders on the effective deployment of ESOPs and other stock plans.  The Institute was established by entrepreneur Bob Beyster, who founded SAIC, a Fortune 500 company.  https://www.rady.ucsd.edu/beyster/

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