Tax-Deferred Wealth: S-Corp ESOPs Can Eliminate Federal Income Tax
An Employee Stock Ownership Plan, or ESOP, is a federally regulated retirement plan that gives employees an ownership interest in a company. As part of its efforts to encourage employee ownership, Congress has given ESOPs remarkably favorable tax treatment.
The Employee Share Ownership Trust, or ESOT, holds the company stock for participating employees. That trust is federally tax-exempt. An S corporation generally passes its taxable income through to its shareholders rather than paying federal income tax at the corporate level. When the ESOT owns an S corporation, the tax-exempt status of the trust becomes particularly important.
If you own an S corporation personally, you pay federal income tax on your share of its earnings, even when the company keeps the cash.
When an ESOT owns 100% of an S corporation, the company's income passes to a tax-exempt shareholder, and no federal income tax is due on its ordinary business earnings.5
If a 100% ESOP-owned S corporation earns $1 million of taxable business income, there is no federal income-tax bill on that $1 million. Cash that would otherwise go to federal income taxes remains available for working capital, equipment, expansion, acquisitions, employee benefits, or other business purposes.
For a profitable company, the economic impact is substantial. Over time, keeping that capital inside the company gives the business considerably more money to work with.
Tax-Deferred Wealth for Employees
Employees also receive favorable tax treatment.
The ESOT holds company stock for participating employees, with shares allocated over time to individual ESOP accounts. Employees don't pay current federal income tax on the value accumulating in those accounts.
Tax is deferred until an employee receives a taxable distribution. If the distribution is rolled over into another eligible retirement account, the tax deferral continues.8
So, employees accumulate meaningful ownership wealth without paying current federal income tax on it.
The 4ESOT Structure
4ESOT takes advantage of this tax treatment without requiring the business owner to sell the operating company to the employee trust.
The ESOT owns a separate S corporation called the Administrative Services Company, or ASC. The ASC provides real administrative and management services to the operating company. Employees receive their ownership benefits through the ASC. The business owner and family are excluded from the ESOP and continue to own the operating company.
The operating company pays reasonable fees for the ASC services and deducts them as ordinary and necessary business expenses.9 Those fees become revenue to the ASC, which pays employee compensation, benefits, and its other business expenses. Because the ESOT owns 100% of the ASC, the ASC's remaining ordinary business income is not subject to federal income tax.5
More capital remains available to grow the business and build employee wealth while the business owner keeps the operating company.