Module 1 - An Overview of Retirement Planning.docx

Esop an employee stock ownership plan esop is another

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ESOP An employee stock ownership plan (ESOP) is another form of defined contribution profit-sharing type plan. This type of plan involves the employer establishing a trust to own shares of the corporation. The shares are then allocated to eligible employee’s individual accounts. The company might fund the trust with shares that it owns (Treasury Stock), with cash from its Balance Sheet that will be used to purchase shares, or from the proceeds from borrowings that will be used to buy shares. More on ESOP loans in a moment. ESOPs are certainly used as a motivational tool for employees, but the real benefit comes from the ability to liquidate a departing owner in a tax-favorable way. The following discussion describes the extent of the tax benefits. Tax Benefits of ESOP One funding method that was mentioned is creating an ESOP loan . This is a scenario in which the ESOP will borrow money to purchase shares of stock (potentially from an owner who is leaving the company). The company guarantees the loan, and the ESOP buy shares either from a departing owner, from a specific group of investors, or from the open market. The company will then hold the shares as collateral against the loan, while they are making loan payments. As loan payments are made, the company will transfer blocks of shares into individual employee accounts. The ESOP concept and the loan feature, in particular, create a unique tax situation for the company. Any contributions that the company makes into the account are tax deductible. It does not matter if the contributions are cash, stock, or cash for ESOP loan repayment. All inflows into the account are deductible! Recall that profit-sharing type plans can only deduct up to 25% of gross compensation for an employee. ESOPs have a provision that extends the allowable deduction beyond 25% if the additional
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money is used to repay the ESOP loan. This increased deduction is a tremendous tax benefit for the company. Dividend-paying companies can also pay a dividend on the shares held in trust within the ESOP (not yet distributed to employee accounts). The previously non-deductible dividends are now transformed into being tax deductible! Additionally, if the company is organized as an S-Corporation (meaning pass- through of profits like a partnership but with liability-sheltering benefits of a corporation), then whatever portion of the profits are attributed to ESOP ownership are not taxed in the current year at the business- level! Those profits are passed-through to the employee’s account balance and are taxed upon ultimate distribution. This means that the profits are not taxed now at the higher corporate rate but later at the employee's lower tax rate in retirement. The most significant ESOP tax benefit is called non-recognition of gains . Internal Revenue Code §1042 states that the owner who is selling shares to the ESOP can defer paying capital gains tax on their shares IF the ESOP owns 30% or more of the company AND the proceeds from buying out the owner are used by the departing owner to purchase shares of other domestic corporations. The replacement securities
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  • Spring '14

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